In a recent lecture on value investing, Columbia Business School Professor Bruce Greenwald perfectly captured the essence of what value investors are looking for in the following quote:
“You are looking for things that are ugly, cheap, boring, out of fashion, small and obscure, or otherwise on the other side of the existing finance industry mania. If it’s on the recommended list of one of the big retail brokerages, my advice to you is to watch out.”Few publicly traded companies are more obscure thanGeorge Risk Industries, a small Nebraska manufacturer of security alarm products. With a market capitalization of $21 million and very low trading volume, the company is far too small to attract attention on Wall Street.
George Risk designs, manufactures, and sells a variety of products with nearly 90% of revenue in the last fiscal year coming from security alarm related products. While the company claims to complete well based on price, product design, and quality, George Risk has also built competitive advantages by specializing in small custom orders that larger competitors often decline. The security products range from burglar alarms, pool alarms, and advanced sensors to detect incursions in unusual places such as skylights.
George Risk has been solidly profitable over the past decade although business has slowed considerably since demand for the company’s products are highly correlated to activity in residential construction. The fact that the company has managed to remain profitable in this environment is a positive sign and an indication of good management, a competitive moat, or a combination of these factors.
The company was founded by George Risk and has been run by President and CEO Ken Risk for the past two decades since the death of his father in 1989. Mr. Risk owns a majority interest in the company with 56.8% of shares outstanding. The presence of a CEO with a controlling interest in a company is often a mixed bag. While minority shareholders have limited influence, the CEO’s incentives are theoretically aligned with maximizing shareholder wealth (of course, provided that he does not pay himself unreasonable compensation). In the case of George Risk, management appears to have reasonable policies on executive compensation and non executive Directors were only paid $150 each in the last fiscal year. However, allocation of free cash flow has been questionable as we discuss below.
Classic Graham Situation
From a valuation standpoint, George Risk Industries is a classic Graham net current asset value situation with NCAV (current assets minus all liabilities) of $4.93 per share as of 10/31/2009 compared to a current market quote of $4.25. What makes the company particularly interesting is the fact that management has chosen to retain a significant portion of earnings over the past decade and invest the proceeds in marketable securities. As of 10/31/2009, the company had $4.28/share of cash and marketable securities on the balance sheet. Investments and securities accounted for $19.1 million as of October 31.
Excess Cash and Investments
In order to properly value George Risk, it is necessary to determine how much excess capital is on the balance sheet. With a current ratio of 38.6 and no long term debt, the company is significantly overcapitalized. A current ratio of 2 or more is normally considered adequate for an industrial business. However, taking a conservative approach would make sense in light of current economic conditions in the housing industry. Let us assume that George Risk requires a current ratio of 10 to safely navigate the recession. This would imply the presence of approximately $19 million of excess investments and securities which represents $3.73/share of value.
Valuation of Business
George Risk has a strong operating record over the past decade. Prior to the recession, operating margins averaged close to 25%. Earnings per share averaged $0.43 per share for the ten year period ending on April 30, 2008 (which in fact could be an understated indication of the business earning power due to cumulative losses in investments that have depressed net income). Since the recession began, sales have declined significantly and margins have been compressed. Earnings per share came in at $0.10 for fiscal 2009 (ending 4/30/2009) and $0.09 for the first half of fiscal 2010 (ending 10/31/2009). The company has remained profitable and is still generating free cash flow.
While the quote on George Risk shares has varied quite a bit over the past decade, it was not unusual for the market to assign a price-earnings ratio of 10 or more prior to the recession. This type of valuation does not seem unreasonable given the strong track record of the company and healthy profit margins. Assuming that George Risk can earn $0.30 by the 2012 to 2014 time frame, the value of the business should be in the neighborhood of $3.00 per share. Discounting a $3.00 in 2012 to today’s present value at approximately 10% would result in a business valuation of around $2.50.
Intrinsic Value = Excess Cash & Investments + Valuation of Business
The combination of the excess cash and marketable securities on the balance sheet, which we have estimated at $3.73 per share, plus the valuation of the ongoing business of $2.50 results in an intrinsic value estimate of approximately $6.25 compared to today’s market quotation of $4.25. This represents a potential upside of close to 50 percent. The stock currently yields 4 percent which should provide some income as well.
There are a number of potential risks that could reduce the upside potential of an investment in George Risk Industries:
- The company is majority controlled by CEO Ken Risk and there is no indication that the company plans to distribute the excess cash and marketable securities or to change their long standing policy of building up a portfolio of marketable securities far in excess of requirements to support the business.
- The investments in marketable securities have failed to produce value for shareholders over the past decade. The company has delegated responsibility for management of the portfolio to an outside manager who has the ability to make trading decisions. It appears that there has been quite a bit of turnover in the portfolio and there is limited disclosure regarding what securities are held.
- The downturn in housing could continue for an extended period (think of a Japan style “lost decade”) and eventually cause George Risk to operate at a loss, thereby reducing the intrinsic value of the ongoing business.
- The company has indicated that it is interested in acquisitions and marketable securities could be liquidated to pursue such acquisitions which may or may not result in the creation of shareholder value.
- Management has been late in filing a number of SEC reports over the past few years and this could indicate that they are having difficulty keeping up with the requirements of being a public company.
George Risk Industries is very illiquid and there are many days when no shares trade. On days when it does trade, the typical volume may be a few thousand shares. As the saying goes, it “trades by appointment”. The bid/ask on the stock is unusually wide with a typical spread of fifty cents or more. Therefore, any orders for the stock must be made using limit orders.
I should note that so far I have found it impossible to purchase this stock anywhere near the prevailing bid despite daily limit orders over the past two weeks. I am viewing this more as an interesting case study in a Graham style investment than an opportunity to put any meaningful amount of funds to work. It is better not to obtain any shares than to offer too much and lose the margin of safety. Perhaps some of my readers will have better luck.
Historical Data and Analysis – Excel 2007 (Source: Rational Walk Analysis)
Historical Data and Analysis – Excel 2003 (Source: Rational Walk Analysis)
George Risk Industries Website
George Risk Industries SEC Filings