"Enlightenment must come little by little -- otherwise it would overwhelm" -- Idries Shah
The pursuit of value is an eclectic process; it is also highly subjective and it rarely fits into a tidy framework or is unveiled through the use of rigid formulas. Value is frequently revealed to the investor in tiny bits and pieces almost as if a person is peering through binoculars and struggling to get them into focus. Above all, successful value investors must be adaptable and their thought process must never become dogmatic. Such were the lessons I was beginning to learn as I entered into the next phrase of my investing journey.
I resume the story in early August of 2001, about one month prior to one of the saddest days in American history, Sept. 11, 2001. For some reason I had suddenly become very apprehensive about the market and for one of the few times in my investing career, I acted completely on impulse. I sold out of about 60 percent of my stock positions. I simply called up my broker one morning (I was not doing my transactions on line at that point) and read off the list companies which I wanted to delete from my investment portfolios.
I recall one thing in particular about going to such a heavy position in cash: It made my life extremely boring for the next few weeks. Still, I held tight to my resolution that I would not make any further investments until the market corrected and I temporarily quit doing stock research altogether. The decision was extremely foolish since it was based upon pure speculation rather than any analysis about the valuations of my holdings. As things would turn out, I did not have to wait before the market corrected.
Like most Americans, I remember exactly what I was doing on Sept. 11, 2001; I was watching CNBC as the horrific drama unfolded. I will never forget watching the backdrop of the Twin Towers when the second plane hit; at that point it was evident to all Americans that their country was under siege from terrorists. Mark Haynes navigated the viewing audience through the terrible ordeal with exquisite poise, never cracking or wavering as Americans sat mesmerized in front of their television sets, watching the shocking developments in stunned silence.
September 11 had a profound effect on the psyche of Americans and without question it had a dramatic influence on their buying and spending patterns. About a month after the attack I attended the Fall Home Show in Omaha and almost none of the vendors did any significant business with one notable exception. The man who sold America flags and retractable flag poles sold out his entire inventory quickly. Many of his customers were forced to endure back order periods of several months before they were able to openly display their love for the United States.
The tragedy had reawakened the patriotic spirit of the American people, drawing its citizens closer together; although it also triggered some temporary changes in their behavior. Americans became much less apt to travel long distances for an extended period, following the tragedy. Airplane traffic dropped dramatically and the following year, businesses which relied upon tourist traffic during the summer months would suffer mightily. It appeared that September 11 had significantly reduced the desire of many Americans to spend their money on things pertaining to leisure and entertainment or much of anything else that did not reflect upon their basic needs. Fortunately, the effects of the attack on the American economy would be temporary in duration.
After the shock and sadness of September 11 began to wane a few days later, I resolved that I was going to spend all my available doing stock research. Free time had become an abundant commodity as my business phone had gone silence following the attack. I began purchasing stocks a few weeks following the tragedy, and within about a month, I was once again fully invested. I would remain fully invested in equities for longer than a decade.
Camtek: An Education in the AOI Sector
One of first investment ideas which I had uncovered during my post 9-11 stock search was Camtek, a small Israeli technology company, ticker symbol CAMT. Camtek had come public a few years prior and had fallen to about $2 a share in the late summer of 2001.
Camtek was an automated optical inspection (AOI) company that designed and manufactured inspection systems for printed circuit boards (PCB). Further, they were in the process of designing systems to inspect semiconductors as well. The logic for investing in AOI companies was simple: Many circuit boards still employed visual inspection and circuits were getting smaller every year.
This miniaturization process was rendering visual inspection obsolete and creating a need for AOI systems. Additionally, semiconductors were becoming ubiquitous in electronic equipment. Flaws in tiny semiconductors were virtually impossible to detect without the aid of an AOI system. Electronic companies would need to purchase the systems to protect against massive recalls which would do substantial damage to their profits as well as their reputations.
AOI companies had little in the way of competition since they held a specialty niche and their systems were protected by patents. Years of R&D would be required to unseat them by way of technological superiority; therefore it made more sense for a larger company to assimilate them should they wish to enter the AOI sector. That said, CAMT was much smaller than its archrival Orbitech (ORBK) in the PCB AOI sector; thus their key to long term growth lied in their penetration into the rapidly expanding semiconductor AOI sector. In that area, their main completion was August Semiconductor.
I originally purchased shares of CAMT at 2.05 in September of 2001; the shares quickly rose to the $4.00 range by the end of the year. At that point, I did not comprehend the extreme cyclicality of the AOI market but it would not be long before I would witness the extreme volatility of these equities first hand. When their revenues and profits began to turn downward, their stock prices would fall off a cliff.
By early 2003, Camtek had lost over 90 percent of its market cap and my original investment had been whittled down by roughly 85%. That was the bad news; the good news was that CAMT was now trading at a large discount to its net current assets. Its market cap was now only about 8 million but the company held net current assets in excess of 30 million. In other words, it was selling for about 25% of its net current assets with its fixed assets and R&D available at no extra charge.
I had never witnessed a net/net proposition before and I started buying, filling limit order after limit order at 30 cents a share. I even filled a few hundred shares for as low as 25 cents. Finally, after I had added about 15,000 shares to my account, my ability to purchase shares at 30 cents subsided. All those shares had cost me well under $5,000.
Camtek stock eventually ascended in price to over seven dollars a share; however, I never sold a share. I can vividly recall proudly viewing the breakdown of my gain/loss statement on one of my monthly statements and becoming awe struck. One 200 share lot that I purchased for $50 was worth over $1,400 at that point. I was particularly enamored with a 4,500 share lot that I had purchased for $1,350 (30 cents a share); it showed a value in excess of $31,000 on my statement. I should have framed that statement and hung it on the wall. To reference the old statement about money: “That statement was what dreams are made of.”
In case you are wondering, I only made peanuts on what should have been a monumental success. You see I never sold a share of Camtek until the autumn of 2008. I exchanged them for shares in their arch rivals Orbitech (OBRK) and Rudolph (RTEC) which had become large net/net propositions (more on those purchases of ORBK and RTEC later in the series).
I even recorded a tax loss carry-forward on my original purchase of CAMT for which I had paid $2.05 per share. It seems that I was a slow learner in regard to the necessity of selling AOI companies long before they entered a cyclical trough in their earnings. Happily, I have since remedied that problem. For informational purposes I must disclose that in the spring, I repurchased shares of CAMT and made a larger purchase in a Cyberoptics (CYBE) another AOI company, which was near a multiyear low at the time.
The Investing Climate in 2002 and 2003
After reinvesting all my funds back into stocks shortly after September 11, I enjoyed a stellar performance until the market engaged in a severe correction in the late summer and early fall of 2002. Following September 11, my portfolios advanced about 25% by year end and by the mid summer of 2002, they had advanced by over 55 percent. Bear in mind that I had never enjoyed any real success in investing prior to that point; therefore I was developing a bit of a “Messiah Complex.” Legendary turf writer Andrew Beyer coined that term to describe the tendency of a horse player to become overconfident following a successful run of luck at the race track.
The late summer of 2002 quickly destroyed any personal delusions I held about shutting down my business and living off my investments. I lost every cent of the 55% in paper gains which I had recorded following September 11 in approximately two months.
Another problem presented itself: My wife was now in full scale panic mode and she was putting me under extreme pressure to sell out of all our equities “while we still had something left.” It seems that she had been talking with one of her friends who had recently gone to cash in her 401-K after knuckling under to the pressure of a rapidly dropping market. My wife thought it would be much more prudent to buy a larger house than to invest our life savings in the market.
Fortunately for us, I refused to knuckle under and resolved not to sell any of our positions. The process was greatly aided by the fact that the market turned almost exactly at the point of my wife’s heaviest insistence to liquidate our positions. In the future, I would use her as a “contrarian indicator” and I made a special point to remind her of her wholesale panic whenever she became nervous in regard to a falling market. The experience became extremely important about six years later when the credit crisis developed and our portfolios would lose well over half of their value in a few short months. To her credit, she weathered that storm extremely well.
After the market reversed in the early fall of 2002, our portfolios began an unprecedented run of good fortune. In 2003, the portfolios were up in excess of 80% and by October of 2007 they had more than quadrupled from their trough, around early October of 2002. It was a great five year run; although I never anticipated that approximately that one year later, the majority of those gains would be sacrificed in merely a few short months. But that is a story to be told later in the series.
NDS Group: Making a Bundle in the Smart Card Business
Sometime in 2002, I developed an interest in NDS Group, formerly ticker symbol NNDS. The main business of NDS was designing and manufacturing the smart cards which are installed in every satellite receiver to prevent the unauthorized use of their signal. The business also had developed some other interesting products (such as digital video recorders (DVR)); however at that time Tivo was dominating the sector.
NDS Group had become highly profitable by 2001 and it appeared that the company had excellent growth possibilities. Satellite TV was still in its early stages and possessed outstanding growth potential. Furthermore, the necessity of protecting satellite signals against piracy virtually insured that the company’s products would continue to flourish.
At the time, NDS Group was 80% owned by News Corp (NWSA) and they were providing the smart cards for all Direct TV (DTV) receivers. Further, they were one of only three smart card providers and one of their competitors, Canal Plus a Vivendi subsidiary, was struggling with maintaining the security of their smart card systems which they were providing to non-News Corp television companies throughout Europe. It seems that the access codes on their systems were turning up on the internet and bootleggers were stealing the signals. EcoStar, which would later be spun off by DISH, was making the same claims back in the 1990s. Both companies maintained that News Corp, acting through its subsidiary NDS Group, was the culprit. To make a long story short, Canal Plus filed a multi-billion dollar lawsuit against News Corp and later on EcoStar would follow suit.
The Canal Plus lawsuit roiled the price of NNDS and when it dropped to around 12 dollars a share, I decided to buy into the stock. At that time, I was much more apt to invest in businesses where the stock dropped as a result of potential litigation. I simply blocked out the risk angle, assuming that powerful New Corp would eventually prevail. Fortunately for me that turned out to be the case since Vivendi (who controlled Canal Plus) was struggling financially at the time. They agreed to drop the lawsuit when News Corp consented to purchase one of Canal Plus’s struggling Italian operations. I figured that settlement would stop the precipitous drop in NNDS; that assumption proved to be incorrect.
One of my major assumptions in the investment was grounded in the belief that News Corp would maintain their alliance with Direct TV and continue to furnish them with their smart cards. Losing that account would severely damage the profits of NNDS and when I entered the investment I believed that News Corp would eventually assimilate Direct TV. Whatever companies that News Corp acquired would obviously use all of the NDS products, insuring sort of a monopoly on their products.
In the fall of 2002, things got worse for NDS Group; EcoStar and Direct TV had attempted to merge and now Direct TV was joining their new alliance in filing a lawsuit against NNDS. It now appeared that NDS Group might be sued out of existence, in addition to losing their smart card account with Direct TV; their contract was set to expire in 2003.
Following the new developments, the stock of NNDS tanked. I believe at one point it fell under five dollars a share. I recall adding considerably to my position at around 7 dollars a share; I nearly tripled my position in the stock. In retrospect, it was a decision that I would not make today; although I probably would have continued to hold on to my original position. At that point in my investing career, I was extremely stubborn about acknowledging that I might have made a mistake in selecting an equity.
As the story unfolded, the merger between DISH and DTV was blocked by the US government and in 2004 NNDS signed a new six year agreement with Direct TV to supply them with smart cards. From that point on the stock rose steadily. I ended up selling all my shares for over 30 dollars a share and recorded my largest long term capital gain to date. The whole scenario took several years to unfold but in the end, my stubbornness had prevailed. Later on I will discuss how my refusal to change my opinion resulted in a financial disaster. Since that time I have become much more conservative and much more apt to change my opinion as the facts and my assumptions of the future profitability a company change. It would seem that I have learned a great deal about managing risk as time has passed.
The story culminated long after I sold my shares in NNDS. The company was eventually taken private for 63 dollars a share in 2008 by News Corp and Permira. In early 2012 Cisco purchased the company; I am unaware of the amount which they paid.
Learning to Love Microcap Stocks
By 2003 I was developing quit an affinity for purchasing microcap stocks. Apparently, my early experience with Camtek had not destroyed my interest in investing in tiny companies. I decided that I would start investing significant capital in microcap stocks for the following reasons: They were largely under appreciated and under followed by the investing community, and they were more apt to be mispriced than their larger brethren.
I started following a rather sleazy microcap tout service which was later exposed by Barron’s; the service was Ceocast.com. The newsletter did not charge its reading audience a fee; rather they billed the companies which they promoted in the form of cash and shares of their stock. The “pump sheet” was full of extremely low-grade companies which typically traded on the Bulletin Board; however occasionally they would promote a real “diamond-in-the-rough” which traded on a reputable exchange.
Lake Gaming (LACO)
I originally discovered Lake Gaming in the Ceocast newsletter and I eventually purchased shares in the stock, but not for the reasons which the newsletter discussed. Upon reviewing the company, I noticed that Mario Gabelli held a significant position in the stock and it was trading at less than 50% of its tangible book value.
As it turned out, one the major assets the company held, was land on the far south portion of Las Vegas, in close proximity to the airport; they were in the process of monetizing that interest by selling the property to time-share companies. The scenario was reminiscent of Aztar. Furthermore, their balance sheet held significant cash and large amounts of money which was owed to them by certain Indian tribes.
At the end of 2002 the company had a book value in excess of 15 dollars per share. I bought my original position for around 7 dollars a share and following the announcement of non-cash accounting restatement, which had no effect on the book value; the stock dipped to about 4 dollars a share. I doubled my position at around $4.25 per share.
Fate was on my side in the case of LACO; although their Indian Gaming business would not drive their earnings in the near term, another catalyst was about to emerge in early 2003. Lyle Berman, the CEO of LACO was an avid poker player and he had an idea that provided the impetus for the stock to move forward.
Berman pioneered the idea of the World Poker Tour (WPT) and sold the concept to the Travel Channel. Watching poker on television had always been boring since the viewing audience could not see the down cards which the players held. Berman remedied that problem by allowing a camera to expose the down cards to the TV audience. That idea suddenly transformed Texas Holdem into a fascinating spectator’s sport. By the end of 2003 the stock had reached its book value of 15 dollars a share and I decided to take my profits, perhaps a bit prematurely. The stock quickly climbed to about 30 dollars a share on sheer momentum.
In the longer term, the decision to sell turned out to be prudent since the TV success of the WPT never translated into significant profits. The idea may have revolutionized the TV viewing of poker events but it never turned LACO into a cash cow.
Forward Industries (FORD)
Another interesting stock that Ceocast promoted was Forward Industries, a tiny distributor of cell phone covers. What made FORD interesting was a promotion from Nokia which supplied anyone who purchased a new Nokia phone with a free cell phone cover. The cover was included in the box of each new cell phone. As it turned out, FORD was supplying the majority of these cell phone covers for US customers.
The company reported in a quarterly filing in late 2004, that US sales of Nokia phones were accelerating and each unit sold would result in the sale of a Forward-produced cell phone cover. However, it seemed that no one was reading the company’s 10Q. I immediately purchased a substantial position in FORD and waited for the company to announce the impending earnings explosion. Ford obliged its shareholders by announcing earnings in the middle of the day. The stock exploded shortly after the announcement and quickly attracted the usual momentum traders who follow the day’s largest gainers list.
When tiny stocks, with extremely low floats announce an earnings explosion, the result is invariably a rapid multibagger. Unfortunately, such parabolic moves upward generally result in a rapid downward descent as well. Therefore, it is prudent to put in a limit sell order at a price well under the likely apex of the upward movement. In other words, what starts off as a buy generally becomes a short candidate in a matter of days or weeks.
In the case of FORD that is exactly what happened; although the apex of the stock explosion was much higher than I could have imagined and the duration of the move defied logic. I sold out following a quick triple in the mid 6 dollar range, only to watch the stock ascend to the high twenties.
The stock continued to ascend for weeks, while all the time the management continued to exercise options and sell their shares as quickly as possible. The buying frenzy lasted much longer than I anticipated and the management had quickly become multimillionaires by exercising exorbitant option package.
When the promotion ended, FORD quickly returned to a price which better reflected its intrinsic value. Unfortunately, none of the temporary windfall was returned to the shareholders in the form of a special dividend. The only real beneficiaries were the management and the shareholders who recognized their capital gains by selling their shares following the large run up in the share price.
I will conclude today’s discussion with another balance sheet play that resulted in my largest gain at that point in my investing career. The company was Fairchild and I had started accumulating shares in the company, following my reentry to the stock market in the fall of 2001.
It was another company in which Mario Gabelli held a significant position. I can not recall for certain, but I believe the stock was mentioned by Gabelli on CNBC. As is typical with a Gabelli holding, the stock held real estate which was understated on the balance sheet. Specifically, the company owned a large shopping center in Long Island which was almost fully occupied and provided the heavily debt-burdened company with a steady cash flow.
Fairchild held another asset which was extremely undervalued and held a much high intrinsic net worth than the shopping center. More specifically, Fairchild owned a large airplane fastener company which had recorded well over a half a billion dollars in sales in fiscal year 2002 and was returning the company over 70 million a year in EBITDA.
One of the reasons Gabelli liked Fairchild was due to the fact they were extremely overleveraged. That may sound strange but “The Chairman” believed that the CEO and controlling shareholder, Jeffrey Steiner, would be required to do a deal to prevent the holding company from being forced into bankruptcy proceedings.
Steiner had a reputation for several things: Most importantly, he could be described as a very successful wheeler/dealer that was known for buying businesses and later selling them for a tidy profit. Secondly, he was one of the most notoriously overcompensated CEOs on Wall Street and he controlled the board of directors at Fairchild.
When he made a successful deal he was handsomely rewarded in the form of a bonus as well as drawing an excessive base salary. Steiner’s legendary greed was profiled in newspaper articles, business magazines and was even the subject of an entire chapter from the book: "In Search of Excess: The Overcompensation of American Executives".
I bought a large position in Fairchild at around three dollars and when the company dropped to slightly over $2 a share I bought considerably more stock. At that point in my investing career is seems that I was fearless. I as recall, the company represented nearly 20% of my entire holdings when I was finished purchasing the stock. Never before had I taken such a large position as a percentage of my entire portfolios.
In mid July of 2002, I awoke and turned on my living room television set; scrolling across the bottom of the CNBC ticker was the following headline: Alcoa buys Fairchild’s fastener division for 657 million in cash. I jumped so high that I almost hit the 8-foot ceiling in my living room. It seems I had hit the mother lode on Fairchild in less than a year’s time.
When I performed the calculations, I figured that the sale alone should be worth at least $6.50 a share to the Fairchild shareholders but the stock quickly settled under six dollars per share. I pondered the situation carefully and decided that Steiner would never return a dime to the Fairchild shareholders. I sold my entire position at around $5.50 a share, deciding to pay the short capital gains taxes on the shares in my taxable accounts.
The decision turned out to be prudent since Steiner eventually squandered the entire windfall without returning a dime to the shareholders. Of course he received a tens of millions as a finder’s fee for executing the transaction. Gabelli on the other hand, decided to maintain his entire position. For once I had out thought “The Chairman.”
Thereafter, Fairchild dropped slowly and steadily, never again reaching the five dollar range. Following the death of Jeffrey Steiner, the company was liquidated at a small percentage of its former price. As I recall it brought a little over a dollar a share.
In the second edition which covers the years between 2001 and 2008, I will profile a number of stocks which involved investment themes, as well as divulging my extensive investments in Chinese stocks. Further, the next article will examine a "perfect storm" which lead to a windfall in the refined sugar business. Last of all, I will reveal an extremely damaging investment which severely compromised my long term returns.
About the author:
John EmersonI 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.