Fructivore Investments

It is only natural that the stock market, having doubled since the March 2009 low, would seem to be running a little short on bargains. And I have a sense, based on purely anecdotal observations, that optimism in the market has reached a local peak in that companies have been punished by the market for putting out respectable, even expectation-beating quarterly earnings. And, of course, then, something in Libya happens and hundreds of billions of dollars of paper wealth have to disappear.

But I have to take the position that whatever is going on in the broader markets, there must be a few bargains out there to go along with all the new overinflated short candidates. One such stock is RR Donnelley (RRD), the largest printer in the country. The printing industry, of course, is under economic pressure, as fewer people are interested in advertising and catalogues, and also under secular pressure from the decline in print directories and the rise of e-books (although the firm claims that their book printing volumes have not been affected by them yet). As a result, RR Donnelley’s sales and free cash flows have declined over a few years. But what has declined more is their share price, moving them into bargain territory. The company, whose debt position is sound and which is rolling up smaller printers in order to reduce what they call “overcapacity” in the sector, now offers a free cash flow yield of 13.3%, when its sales and free cash flow are showing signs of stabilizing. They also offer a generous dividend yield of 5.5%.

My full opinion of RR Donnelley may be found here.

http://seekingalpha.com/article/254219-r-r-donnelly-strong-free-cash-flow-attractive-valuation

I heartily recommend this company as a candidate for portfolio inclusion.

One of the great debates among fundamental investors, whether they are value investors or whether they should be value investors, is the question of bottom-up or top-down. The top-down approach involves examining the economic outlook, the state of the financial markets, and the trends among the sectors, in order to determine the best stocks in the best sectors, taking into account the markets and the economy. The proponents of this view look upon this method as providing three additional checks on the right decision. The bottom-up investors describe it instead as three more ways to make a mistake. Furthermore, what if the economy points one way and the market points another, as is often the case? What if the sector is richly priced but an individual stock has been left behind? Most value investors definitely fall into the bottom-up category, and so do I.

However, I have considered my habit of finding companies that come in pairs, and as such I am willing to concede that if a particular stock is attractive, then other similar stocks are at least worthy of consideration. I suppose you could call it the mountain climbing approach: bottom to top to bottom. In that vein, I thought I would examine Sinclair Broadcasting Group (SBGI), which, like Belo Corp, is a geographically diverse television broadcaster that has  suffered from large noncash impairments and is now seeing stabilization in its operations that is allowing it to deleverage.

Sinclair Broadcasting owns 58 stations in 35 markets, most of which are network affiliates. The company has also chosen to diversify into various other ventures, such as a television broadcasting equipment company, a security alarm service provider, a sign maker, and some real estate speculations. Damodaran, in his Damodaran on Valuation, concludes that the market tends to punish diversified companies and that investors are more or less capable of diversifying on their own, particularly where, as here, there is hardly any possibility of vertical integration. As a result, the market was cheered when the company announced recently that they would be divesting some of its noncore assets, as well as reinstating its dividend. Their bonds, though rated firmly in the junk area, trade roughly at par. Their debts are still ample, and I can see them devoting much of their free cash flow towards paying them down in future, dividend or no.

Apart from large goodwill writeoffs, they have been profitable for the last five years, and revenues have recovered since the 2008 and 2009 slump, assisted by political advertising.  Sinclair’s current market cap is $1.04 billion, which, as I shall calculate later, is approximately 13 times their annual free cash flows, which I would not consider cheap, particularly as those cash flows may be earmarked for debt repayment and as such, under a curious paradox of valuation methods, may not be considered free.

The following is my estimate of their free cash flows. Like many companies in the current economy, Sinclair Group has been able to produce some excess depreciation. Their free cash flows have been remarkably stable despite the economic volatility. As for their 2010 year to date figures, the company has reported that 2010 was an excellent period, buoyed by the Super Bowl, a rebound in automotive advertisements, and an unusually vitriolic election season. However, they have not published the full set of financial statements, and also such a good quarter may serve to distort rather than inform our investment views, so I have not included it.

*ASC 470-20 requires companies that issue convertible debts that may be settled in cash, of which Sinclair Group has three separate convertible issues,  to record the value of the convertible debt in two pieces, the debt component based on the value of a similar nonconvertible debt, and the equity component being the remainder of the face value of the bonds. This equity component must be amortized over the life of the convertible bonds, and most companies record this amortization as an interest expense. I have already made my views on this accounting rule clear: This rule obscures, rather than clarifies, financial statements, requires companies to record an expense that does not exist to amortize an asset that never existed, and does not even appropriately value the conversion privilege, which should be assessed using option pricing, because of its linear assumptions and complete disregard of price movements; the conversion price of the bonds is above 20 and the current share price of Sinclair Group is a mere 12 and change.

At any rate, I expect full year 2010 results apart from the unusually good political advertising season to be somewhere in the mid to high 70 million in free cash flows. If we call it 77, that is a free cash flow multiple of 13.5x, or a yield of 7.4%. As I stated, the company has also announced the resumption of its 48 cent per year dividend, which will consume $38.5 million per year, leaving $40 million per year to pay down debts with. Considering that Sinclair Group has over $1.1 billion in debts, and their interest coverage is somewhat worrisome at roughly 2x, they may be working at debt repayment for some time.

So, where does that leave us? Sinclair Broadcasting has a fairly robust operation and a debt level that is high but manageable, and has shown recent improvement in its operation–not that the wise value investor would project any kind of trend from these improvements. However, the price to free cash flow yield for the company is too high, in my view, especially considering that some of their free cash flow is to be used to pay down debt, which has a comparatively low after-tax return. Other than that, it is in much the same situation as our attractive-looking Belo Corp,  and if there is a significant pullback in prices (unlikely in the current market but still possible if some of the optimism is bled out), it should constitute a very attractive purchase. But as things stand, the price is too high.

I have over the last few months been forming the conclusion that Cisco offers an attractive potential return situation based on its earnings yield from operations. The company, with a market cap of $105 billion, is sitting on $35 billion in excess bonds because the CEO is unwilling to repatriate its overseas profits under the current tax scheme. Take those away, and we find that Cisco’s core operations produce some very juicy returns.

Last night, Cisco reported reasonable earnings and announced that its future growth is not at an end. Regular readers will know what I think about future growth, but Cisco is reasonably priced without it and a screaming buy with it. The market inexplicably punished Cisco with a 13% decline in share prices today, which I would describe as nothing short of a gift for new purchasers.

I have my full views on Cisco on my seekingalpha page at http://seekingalpha.com/article/252139-cisco-looking-beyond-results-from-a-single-quarter. Do please come by.

Future economic historians may refer to the period beginning in 2009 and continuing for some years into the future as the era of deleveraging, at least for everyone except the U.S. government. I have often voiced the opinion on this site that companies that are in compliance with the times by voluntarily paying down debt early are an attractive prospect. This has informed my recommendations of Belo Corporation, Entercom, and even Chiquita Brands. However, as with many things in the stock market, the benefit of deleveraging depends on the valuation model we use. A good review of equity valuation models is contained in Damodaran’s useful toolkit, Damodaran on Valuation. Although value investing adds certain nuances based on stability of cash flows, credit quality, and other qualitative factors, a basic knowledge of valuation according to orthodox practice cannot fail to be useful to value investors, even if only for the reason that other market participants use it.

The simplest method of valuation is the dividend discount model, where the future dividends of a company are discounted to a present value based on whatever required return on equity the investor chooses. Although this method does rightly focus people’s minds on cash returns, this method has several defects. First, it requires investors to project the future course of dividend payments, and investors are perennially incapable of seeing into the future. Second, particularly in the current era of low dividend yields, it often transpires that even a mature company does not pay out anywhere near as much in dividends as it can.

This led to the modern approach of valuing companies based on free cash flow yields. Free cash flow, of course, is the money that a company can afford to pay out of its cash flow after making due provision for maintaining its earnings power. The logic behind the use of free cash flow analysis is that a company is valued based on its potential dividends rather than its actual dividends, and moves us closer to the concept of profit in the economic sense.

However, the confluence of the two models often creates paradoxical results. I will demonstrate this paradox by simplifying the numbers and capital structure of Belo Corp. The company is capitalized with about $1 billion of debt at a yield of 7%, and produces $70 million a year in free cash flow. If we allow that a 10x multiple is a reasonably conservative valuation, we would expect the equity of the company to be worth $700 million. However, the company, although its debt situation is reasonably stable and sustainable, chooses to devote all of its free cash flow to paying down debt

A year later the company would save itself $5 million in interest, which comes to about $3 million after taxes. If we keep the multiple at its conservative level, we will find that the value for the new company becomes $730 million dollars. The paradox lies in that we have clearly earned $70 million dollars in free cash flow over the year and should be $70 million better off, but we have a company at the end of the year that has no more cash than it did at the beginning of the year and is worth only $30 million more.

Now, even Damodaran, although he does not go into great detail, acknowledges that free cash flow does not include debt repayments , but logically, how can this cash flow not be “free” when management could simply roll their debts over as they fall due and keep the money.Even so, management’s decision to pay down debt does move us back into the more primitive world of dividend discounts, because using the money to buy back debt is the equivalent of canceling a dividend for that year, so the view that $30 million, rather than $70 million, is our “true” earnings may be have some logical support. And applying the dividend discount model consistently, we can conclude that $730 million is the correct value only if management decides not to pay down debt next year, and it just as naturally follows that $700 million was the correct value only if management decided not pay down debt this year.

This puts the dividend-discount investor in the always-uncomfortable position of trying to see in the future, and guessing at what point the capricious opinion of management will decide that a given amount of debt paid down is enough, calculating the free cash flow value on that date, and discounting that figure to present value. As investors are, again, incapable of predicting the future accurately, this makes these companies very difficult to identify as inexpensive.

Free cash flow is meant to calculate an investor’s returns on an economic basis, but the trouble is that the company is using the money that is required to produce here a 10% return on an investment in order to effectively “invest” in the company’s own debts, which action here produces a return of 4.2% on an after-tax basis, rather than giving the money to the shareholders or at least keeping it for their potential future benefit, to allow them to seek higher returns on their own. This difference between 4.2% and 10% is presumably where the missing $40 million went. True, shareholder equity increases by the full $70 million, the liquidation value of the equity is improved by the full $70 million, but on a going-concern basis the liquidation event is assumed to occur many years in the indefinite future—and in fact, the paying down of debt may be exactly what pushes the liquidation date out further. I do not know the resolution to this situation.

If conservativeness in valuation methods means anything, it counsels us to use the lower calculated value whenever there is one, particularly if the decisions of management are viewed as forcing shareholders to invest in the company’s debts. And yet, the efficacy of free cash flow analysis has a long pedigree, and it may be that the company derives benefits from paying down debt in terms of the diminished perceptions in the market of the possibility of financial distress. Of course, prudent value investors assure themselves first of all that financial distress is highly unlikely, but the broader market may take more convincing, and there may be a multiple expansion that could be attractive to the more trader-oriented types. As it stands, though, I can only conclude that companies that are deleveraging ought to be held to a more stringent than normal standard for what constitutes a compellingly low valuation.

Hello, everyone. I have written an article about Belo Corporation, a television broadcaster that owns major network affiliates in several markets. It currently trades at an attractive multiple to its free cash flow, and is deleveraging at a rapid pace in order to address its debt situation, an endeavor which I believe will be successful.

The article is available at http://seekingalpha.com/article/249885-belo-corp-television-stock-stabilizing-at-an-attractive-price, as part of my participation in the Seeking Alpha premium authors program. I hope you will all read it there.

My habit of finding companies that come in pairs is running true to form, although I think this could be the longest period between matching up the pairs. More than a year ago, I profiled Rayonier, a timber company that produces forest products and that got to take advantage of the black liquor tax credit, and now I have found Boise Inc. (BZ), a paper manufacturer that also got to take advantage of the black liquor tax credit.

Boise Inc. is the third largest North American manufacturer of uncoated freesheet paper products. They make make paper cut to office size, and also produce paper suitable for use in envelopes or business forms or commercial printing, as well as labels. They also manufacture newsprint and corrugating medium for cardboard as well as other flexible packaging products. Most interesting, I think, is that they have a supply contract with OfficeMax, whereby OfficeMax will buy all the office paper that they can produce, in exchange for them offering a more stable pricing regime than the open market can provide. This arrangement, which falls due for renegotiation in 2012, accounts for 1/4 of Boise Inc.’s total office paper sales. Of course, the demand for paper and forms depends to a significant degree on the overall level of economic activity, and indeed the firm was forced to close down one of its facilities in 2008. Also there is a movement towards paperless offices and electronic forms, which the company sees as a source of long-term pressure. On the other hand, there is no such thing as electronic cardboard.

Boise Inc. also sells transport services to other users when they have the available capacity. I mention this not because it contributes a great deal to their bottom line–revenue from this field amounts to about $60 million a year out of $2 billion in total revenues–but because I like to see companies willing to pursue every avenue of potential profit. It reminds me of Compass Minerals leasing out a disused salt mine shaft to a records storage company.

Turning now to the figures, the black liquor tax credit that the company earned in 2009 is no longer available and should not be taken into account in examining their future results. Removing that amount, plus removing the gains and losses they made from refinancing their debt in 2009, they had $142 million in operating earnings. Adding back in $131 million in depreciation and subtracting $77 million in capital expenditures produces estimated operating cash flow of $196 million. Interest paid in 2009 was $83 million, producing an interest coverage ratio of 2.36x, which leaves $113 million in estimated pretax cash flow, which after, say, 40% in state and federal taxes comes to $67.8 million in estimated free cash flow.

2010 showed even better results, although as Boise Inc. considers itself a cyclical company they may have derived some of this improved performance from a confluence of excellent conditions, as business activity improved somewhat over 2009 while cost of inputs did not. Sales increased by 6% and operating expenses by less than 2%.  At any rate, for the first three quarters of 2010 (the fourth quarter report is due in a few weeks), we have $134 million in operating income. Add in 103 million in depreciation and take out 67 million in capital expenditures and we have operating cash flow of $170 million, as compared to $130 million for the same figure for the first three quarters of 2009. The firm paid $48 million in interest over the same period, producing an interest coverage ratio of 3.54x, leaving pretax cash flow of $122 million. If we multiply this figure by 4/3 to fill out the year and subtract 40% for taxes we get $97.6 million in estimated free cash flow for 2010. Based on current prices, we have a price/free cash flow ratio of 7, which I think is attractive.

In 2008, Boise Inc. did not do so well; they had operating earnings of $40 million and negative reported earnings and estimated free cash flow, owing in part to restructuring costs. In 2007, the predecessor company still produced about $90 million in estimated free cash flow.

Unfortunately, the calculated price/free cash flow ratio does not tell the whole story. Boise Inc. has outstanding 42 million shares worth of warrants at a price of $7.50. The company now has 80.5 million shares outstanding at a price of $8.51. I would say, taking one thing with another, that a free cash flow multiple of 9x would not be unreasonable for Boise Inc., and based on estimated free cash flow of $97.6 million for the year, the warrantless company is worth $878 million, or $10.91 per share. The warrants, if exercised, would add $316 million in cash, so if all the warrants are exercised the company will be worth $1.194 billion and have 122.5 million shares outstanding, which translates to a price target of $9.74. This stacks up attractively against the current price of $8.51.

Turning to the balance sheet, significant debt levels do exist at this company, with $1.96 billion in total assets weighed against $750 million in long-term debt, $327 million in current liabilities and $227 million in “other.” As calculated above, though, interest is well-covered based on 2010 earnings, and indeed their 9% bonds due 2017 now trade at a premium price of 111 with a credit rating of BB, fairly high on the subinvestment grade levels. Long term debt levels have declined by $35 million since the beginning of 2010, and $226 million in 2009, thanks no doubt to the black liquor tax credit. I will also note that in the first three quarters of 2009, the company has built up an additional $100 million dollars in cash holdings. Now, many companies have been building up cash, but since Boise Inc. pays no dividend and produces enough cash to be able to afford one, I would be very interested to know what the firm’s plans are for that money, particularly with those warrants expiring in June of this year and ripe to be bought back.

As a final note Boise Inc.’s financial statements are very lengthy and detailed. Clearly this is a firm that takes the disclosure requirements seriously. On the whole, I find that Boise Inc. is an attractive paper company at current prices, and definitely a candidate for portfolio inclusion.

At the beginning of this week I posted a review of some of my recommendations, citing Chiquita Brands (CQB) as an attractive purchase that never went anywhere, and Coinstar (CSTR) as a compelling short idea that had dramatically gone against me on a wave of optimism.

Imagine my surprise to see Chiquita Brands up over 12% for the week with no news I can think of, and Coinstar down after hours by about 25% on the announcement that next year’s earnings will be lower than previously projected. I find it a telling commentary on growth stock mentality when millions of dollars can vanish literally overnight because a wild guess has been lowered.

It makes me think that I should post reviews more often.

Many of you may have no doubt noticed that my approach to investing is largely quantitative, concerned with free cash flow yields, interest coverage ratios, the gap between depreciation and capital expenditure, net working capital position, and other financial vital statistics. This should not be surprising; I take the position that corporations are machines that turn cash into (hopefully) more cash, and as a result these basic company-specific figures mean more to me than the penumbras and emanations of economic and sector analyses that characterize the top-down approach of non-value investors.

The emphasis on a company’s facts and figures also serves to give us a good sense of what to look for in a company.  We can identify a potential investment, or at least eliminate an unsuitable one on the basis of the numbers. Fortunately, there are a number of sources that track the financial details of a company in obsessive detail and allow searching. It is, of course, indispensible to follow the advice of Ben Graham in his vital Security Analysis, and go through the accounting in searching detail in order to determine whether the reported numbers are representative of reality or have to be adjusted for nonrecurring events, noncash writeoffs, or nonexistent interest expenses due to convertible debt. But we can at least narrow down our list of candidates if we look for the right numbers, and for that we need the right screener.

The Yahoo! Finance Java-based stock screener (not the basic HTML one) is a good choice, allowing screening for a large family of variables, including dividend yields, return on equity, and the ever-popular P/E ratio. However, the P/E ratio does not tell the whole story, owing to gaps between depreciation and capital expenditures, nonrecurring events, the fallout of an economic crisis, or just simple application of accounting rules. Linn Energy, for example, had a P/E ratio of 1.39 owing to its oil price hedges, because it had to report the income from its hedges but not the offsetting losses in its future production that the hedges were hedging. However, Yahoo’s screener does not have an entry for free cash flow yields; the closest it gets is a screen for entity value to free cash flow ratios, and that measure is often distorted by an unusual cash flow structure. Also, it’s not immediately clear how they compute the entity value or free cash flow, because I have found some missing entries. However, the screener does have the advantage of letting you define your own cutoff points for the screen. If you wanted to know which companies had, say, a price/sales ratio of exactly between .93 and .95, Yahoo! will help.

For net-net companies, Ben Graham’s other favorites, an ordinary screener will not do, because the price/book ratio alone is not specific enough, and combining it with other measures such as the current assets to current liabilities ratio or total debt/equity is likely to produce an endless list of false positives and negatives. Fortunately, someone has assembled a screen that uses data pulled from Yahoo! to identify these companies directly. I have found some issues with Yahoo!’s own data being wrong, which occasionally affects the screen as well, but as I never invest without reading at least a 10-K and the latest 10-Q if applicable, these errors are always caught in time. The author of the screen has also added certain other calculations such as the Piotroski score, which is an estimate of what I would call “fundamental momentum.” I find this a useful screen for identifying potential opportunities on the balance sheet, and it definitely has the advantage of being free.

I have recently discovered a third screen at finviz.com that actually will screen for price/free cash flow, a thing I have been searching for for some time. However, it does not allow you to set your own limits, and with theirs you have the choice of looking for a multiple of five or ten. Perhaps 5x catches ltoo few and 10x catches too many, but there are additions to the screen that can be added, and I think it is best to cast a wide net, as the vital work of actually finding suitable investments from the screen results is the lengthier (and more fun) part.

However, I have not found a screen that can do what I really want it to do, and that is to center on historical data. I like to look for companies that not only have a high cash flow yield at present, which could be a fluke, but which also have been able to sustain reasonably high earnings in the past, which gives me greater confidence. In fact, many value investors are guided by what they call the Graham-Dodd P/E ratios, which average earnings over ten years. as I tend to be skeptical about growth, and the usefulness of projecting it, I like the concept. However, it is also the case that a company now is almost always not the same as it was ten years ago, so perhaps taking an exponential average, or even calculating an average profit margin over ten years and applying it to current sales might be in order, as suggested by Damodaran in his useful toolbox, The Dark Side of Valuation, as a method for dealing with cyclical companies.

I have also started to see the logic of companies that are aggressively paying down debt. After the financial crisis, many people began to see that liquidity is a thing that can dry up, and beyond that, at any given time there are always companies in the market that need debt reduction. Furthermore, many economists have noted that consumers and corporations have been reducing their debt levels faster than the federal government has been expanding its (and, if you’re a Keynesian, that is the very reason why the government has to keep expanding its debts). But whatever one’s feelings about economics, there are sound reasons why companies should deleverage in uncertain times, and it is wise to get on the right side of the trade. After all, cutting debts certainly improves future earnings power, and as companies with high debts often produce lower profits and nearly always trade at lower multiples, the tax advantages of debt, and the multiple expansion that comes from a distressed debt situation resolving makes the return from paying down high debts a very attractive use of free cash flow. To that end, I want a screener that can track debt repayments and overall debt/equity levels over a period of years, so that I can dig into the reports and know if the company is following a wise strategy.

At any rate, I haven’t found any screener like that online, at least for free. I suppose a screener with all the features I have in mind would be useful enough, if it exists, that its designers can charge for it. So, I shall have to make do with what I can, and keep an eye open for new tools.

So, my loyal readers who have been keeping count will know that this to be my 100^th post. I thought I would celebrate this exciting occasion with a review of how some of my recommendations have worked out. I know hindsight makes everything look more certain than it was, but it is definitely a useful exercise to see where my investing went well and where it went amiss. So I thought I would look at what price my recommendations wound up at, whether I would have sold along the way, and whether the investing thesis still applies.

I thought it would be best to go by category. My favorite category, of course, is companies with high and stable free cash flows. When these stocks are selling at very low multiples of free cash flow, as they often are, it is the clearest evidence to me that the market frequently and exploitably gets things wrong.

The first example of such a company was Qwest, which I recommended way back in June of 2009. Back then it was at $3.86 cents, and after the CenturyTel acquisition was announced last year, which unlocked a recognition of Qwest’s true value, the company ultimately hit what I consider a fair price of $6.95, and actually moved beyond it. All the while the company maintained its dividend, which at the time of recommendation yielded roughly 8%. I would call that a success.

Windstream, which I recommended in mid-July of 2009 at $8, was a similar success. It is now at $13.50, curiously nearly a dollar off of its peak, and has continued its very generous but well-covered dividend of 12.5%. As I calculated, it is perhaps finally fairly valued based on its recent free cash flow levels, and I will want to see how its acquisitions contribute (or fail to contribute) to future earnings levels. Unfortunately, Windstream’s recent acquisitions have largely been of private companies which have not released sufficient data to allow me to value them independently. Even so, I cannot say that Windstream is definitely overpriced and therefore I will continue to hold it.

The next idea in this vein was Compass Minerals, from late August 2009. At the time they were at 52.56 with a P/E ratio of 9.5. After my recommendation they spent a lengthy period drifting more or less straight upward to a little over their current price of $87.79 and a P/E ratio of over 19. Not bad, one might say, but I should point out that although salt for roads is an essential product, and although Compass Minerals holds some of the most lucrative salt mines in the world, salt is inexpensive and bulky enough that cost of transporting it limits the geographical area that the company can cover. Also, global warming or not, demand is also subject to physical limitations, and of course state and municipal budgets are under pressure. As a result, I would call Compass Minerals overpriced now and would definitely have called for selling it somewhere along the way up.

My next discovery was Breitburn Energy Partners at the end of September 2009. This was a textbook value case. Its management had decided to suspend its dividend for liquidity reasons, which caused a mass exodus of investors despite the fact that Breitburn was still making the same money, just not distributing it. At the time they were selling at $10.83, and are now selling at $21, as they were able to resume their distributions, although not at their historical level of 50 cents a quarter. They hold a number of long-lived assets and engage in a number of hedges to lower their exposure to falling oil prices. They have an earnings yield of around 10% at present, which makes me at least consider selling. However, Linn Energy, another recommendation of mine in a similar vein (went from 22.04 when I recommended them to a present 38.21), and I sold them only when their earnings yield dropped to 8%. So, their hedging strategy does give me some confidence that their cash flows will be stable enough to justify a lower than normal earnings yield, and based on Breitburn’s current earnings an 8% yield would put the target price at around $25, so there is still an upside here.

Just so you don’t think this post is solely about bragging, there are times when this strategy has not (yet) produced results. Chiquita Brands has an attractive present and prospective earnings yield, with a price/free cash flow ratio of 6 when I recommended it. Earnings have declined somewhat as a result of weak pricing in Europe, but on the whole the company still has an attractive price/free cash flow ratio, and when Europe implements the tariff liberalization that the WTO forced on them, I expect that earnings will improve further. Furthermore, as 2/3 of their sales are in Europe, investors who are concerned about the future of the US dollar might find them attractive on this ground too. Nonetheless, I recommended them in February 2010 at 15.13 and they are now at 13.82. I remain confident that their true earnings power will ultimately be recognized by the market, and of course the essence of value investing is that individual market participants can decide that a company is attractively priced without the need for the market to immediately confirm it.

On the whole, though, I have found that these pure free cash flow plays have produced more than satisfactory results, and from among the various categories of stocks I consider, they give me the greatest confidence of good results.

Alongside these companies that are cheap based purely on free cash flow, I have examined on this website companies that do not necessarily offer outsize free cash flow yields, but also have other attributes that make them attractive.

The first such stock is Rayonier, which owns a large amount of timber acreage and has a vertically integrated paper and wood fiber products operation. The large holding of land serves as an excellent hedge against inflation, which could justify a larger multiple. When I recommended it in August of 2009 it had a P/E ratio of 20 and a price of $39.93. They have had some earnings growth, but the price has been propelled to $57.35. The current price/free cash flow ratio has declined to approximately 16, although capital expenditures are not lower than the historical levels. Even so, I do not feel comfortable projecting continual growth, and as I have a sanguine view of inflation I would say that Rayonier is somewhat overpriced at this time.

The second such stock is Ross Stores, which I recommended on the grounds that as a discount store, its competitive position becomes stronger during a recession. In the jargon of Wall Street, then, it is a countercyclical stock. Last December when I suggested it, it had a P/E ratio of 13.6 and a price of $42.37. Now it is at $63.95 and, thanks to some sales growth and store openings, earnings have increased, allowing Ross to retain a P/E ratio of 14.5. I wonder, though, how many customers will go back to non-discount stores when the economy improves, and how many customers, like me, enjoy the treasure hunt aspect of Ross and would shop there regardless.

Even Seth Klarman has advocated that finding cheap hedges where they are available should be part of a value strategy. As a result, companies that by dint of their assets or market niche offer additional protection from certain events occurring would perhaps be entitled to a premium. However, it would be dangerous to take this too far; a company’s hedging characteristics should serve as a sweetener and not itself the basis of an investment.

My third category of stocks I considered bargains based on balance sheet characteristics. These companies have a long history in value investing circles; Ben Graham himself liked the idea of net-nets, companies for which the net of their cash, receivables, and inventories over all of a company’s liabilities is still less than the company’s market cap. In a normally functioning market these situations are definitely anomalous, and are often indicative of some weakness, impending negative contingency, or inaccuracy in the accounting itself. However, if the companies are profitable and operationally sound, a set of them should in theory offer attractive results as the market anomaly, or at least the market pessimism is resolved. And at any rate, the earnings of the company itself perhaps can be discounted at a lower rate than the usual equity rate because the stock is already trading at below the theoretical price floor. My returns from this set of recommendations is perhaps significantly below that of the pure free cash flow plays, although the timing of the recommendations, when the market returned to normalcy and then to what looks like great optimism in the present situation may have something to do with it.

The first net-net I recommended was Keytronic at $2.38, which at the time had a net current asset value of $3.37. When a quarterly earnings report indicated that Keytronic was returning to its normal earnings power, that gap was resolved very quickly. The stock is now at $5.62, but its current net current asset position is $37.3 million, which is a share price of $3.60. Keytronic has got its earning power back into gear, having produced $6.18 million in earnings for the last four quarters (after applying a tax rate of 35% to their pretax earnings, as they received a large tax refund in the 3^rd quarter of 2010). This gives them a P/E ratio of 9.41. However, Keytronic has also made a significant increase in capital expenditures, which has resulted in free cash flow generation for the last four quarters of only $3.4 million. It may be that they are expanding their capital in the face of new business opportunities and earnings growth, but conservativeness calls for being suspicious of this opportunity and viewing all of this expenditure as merely necessary to maintain current earnings. This being the case, the net-net thesis and ordinary free cash flow analysis call for the stock to have been sold at a lower price. On the whole, though, this was a successful recommendation.

My next recommendation in this vein was the very small Coast Distribution System (CRV), which I recommended at the beginning of 2010. It had a market cap of $17.4 million and had a net current asset value of $25.6 million. The company is still profitable, having a present free cash flow yield of just under 7%; however, prices have moved from $3.91 when I made my recommendation to a whopping $3.99 today. Even so, the net current asset position is still $25.7 million so this experiment, although not successful, is still ongoing.

Jewett Cameron, another tiny company in this vein, showed better results. At the time I recommended it in February of 2010, it sold at $6.21 with a market cap of $14 million and a net current asset position of $16 million. They also offered a P/E ratio of 7. Now they sell at $9.36, or $21.6 million in market cap. Earnings have been flat, giving them a current P/E ratio of 11.28 and its net current asset position of $17.3 million, so I would probably have wanted to sell somewhere along the way up.

The final entry in this field is Microfinancial, a company that finances business leases. It was recommended at the end of January 2010 at $3.21 and it is now at $4.04. The P/E ratio still stands at 11 and a half and the company, which was at a 40% discount to the net value of its loan portfolio at the time of recommendation, is still at a 17.5% discount to its asset value. However, as a financial company the book value of its portfolio is unreliable and subject to writeoffs, so Microfinancial should perhaps not be taken at face value.

On the whole, though, I think the results of this foray into net-nets can be pronounced a success, particularly since these results are theoretically less dependent on shifts in market sentiment.

The next category of stocks I have considered are companies that operate domestically in China. The stocks are cheap by the numbers, frequently with single-digit P/E ratios and rapid growth. However, upon consideration I have found that the legal issues surrounding these stocks, specifically the difficulty of actually getting money out of China, the fact that many key players are outside of the SEC’s jurisdiction, and finally the fact that China is inevitably a bubble, has caused me to consider that the attractive valuations are an insufficient attraction. Unfortunately, the stocks have not given me some face-saving performance until I have reached this decision. American Lorain, which I recommended in October of 2009, has gone from $3.01 then to $2.65 now. Skypeople Fruit Juice, recommended in April of 2010 at $6.15 is now at $4.33. China Security and Surveillance, recommended in May of 2010 at $5.16 is now at $4.97. And finally, HQ Sustainable, also recommended in May 2010 at $5.49 is now at $4.89.

Another category with disappointing results has been in my short recommendations. As I stated before the market has moved from pessimism to startling optimism, and of course the companies that trade at high valuations, which attract optimists already, have not been immune to this trend. The trouble is that the higher the stocks go, as long as earnings or prospects do not improve, the more obvious the short theory becomes even as the losses accumulate. Now, given the results from the long side, one is left to wonder why I would even consider it necessary to be short. However, there is evidence that a long value/short strategy generates outperformance, at least in flat markets, and I am led to believe that my results from some of my value stocks are atypical.

The first short candidate, in June of 2009, was Coinstar. At the time it was at $25.91 and now it is at $57.58, most likely from the spillover effect of Netflix. I suppose that technically I never did recommend covering, but in 2009 the stock began advancing immediately after I made my call, only to drift back downwards after a disappointing third quarter. I was able to cover at a small profit at that point. Their free cash flow is still virtually nonexistent, and earnings are perhaps a little better than last year as compared to last year as sales are up.

The next set of short candidates comes from the tech sector. The market optimism seems to naturally gravitate towards anything that shows signs of growth, and in theory businesses expanding their computer capital is possibly in the offing as the economy recovers. However, these firms still trade at ridiculous cash flow multiples that would not make sense even if these companies produce every quantum of growth that they are projecting. In September of 2010 I suggested shorting Concur, which sells expense tracking software…in the cloud! At the time it was at $52.01 and is now at $53.53. Red Hat, the open source Linux provider, I suggested shorting the very next week at $40.82, and it is now at $45.71. I suppose I can comfort myself that Concur has failed to beat the market, and Red Hat has matched it over the period studied. Netsuite, however, I recommended shorting in November of 2010 at $25.10 and it is now at $28.15. As these are recent positions and very little in the companies’ prospects have changed, I believe that this trade is still “alive.” But I do recall that in early October a firm named Equinix, which provides data center services to enterprises, made a surprisingly bad earnings announcement that knocked Concur, Red Hat, and a number of companies active in the cloud computing space down by about 6%. I remember thinking that it would probably have been a good time to take profits. Normally I would like to think of shorts as a lengthy commitment, but past experiences have convinced me that it might be better to take profits where I can find them. Of course, my past experiences have been during a bull market.

My next category of shorts have been cell phone tower companies. The tech companies have generally pristine balance sheets, indicating that the investing community that may be fool enough to buy them is still smart enough not to lend money to them. However, the cell phone tower companies I identified have convinced people to lend them money, and perhaps too much money as they are approaching the limit of their debt covenants. In October 2010 I suggested shorting SBA Communications at $40.28 and it is now at $39.66, and later that month I suggested shorting Crown Castle at $42.74 and it is now at $42.60. I don’t think anything at these companies has improved to the point that it would justify multiples of more than 30.

Although I think of all these stocks as potential short candidates, I have been considering the wisdom of taking the short side of stocks using long-dated puts instead of ordinary short selling.

The final category of holdings that interests me is junk bonds, and those have been going very well. Value investing techniques do not apply only to stocks, and junk bond investing, although it requires at least conversance with the US Bankruptcy Code, offers lucrative opportunities particularly in periods where the market is seen as coming out of recession and returning to normalcy.

My very first recommendation on this site was in fact junk bonds, specifically the bonds of Bon-Ton department stores at $46 and with a yield to maturity of 34%. The bonds currently trade at 102.75 and yielding about their 10% coupon. The total return from this transaction, counting interest payments, is roughly 146% over a year and a half, a very satisfying result. However, on reflection they do not have the bankruptcy robustness at least on the income side, as interest is covered approximately once. At the time of the recommendation the asset side looked a little more promising, although with the bonds at par I don’t believe the asset coverage picture is so attractive. At any rate, obviously with the bonds trading at par there is little upside, apart from the 10% coupon itself, in them and therefore it might be time to exit the position and find more fruitful locales.

My next idea in August of 2010 was the bonds of Western Refining, a small oil refining company. At the time the bonds were selling at 76, and according to finra.org the bonds recently traded at 120. The bonds are convertible, and they have recently crossed the conversion price of $10.80. The yield based on the current price is actually negative, which leads me to believe that the bond price now entirely represents the stock value. At any rate, I believe that the bonds, which are not fully robust to bankruptcy, to be definitely overpriced at this point.

The next junk bonds that intrigue me are my Indian casino bonds, from both the Mohegan Tribal Gaming Authority and the River Rock casino. There was a recent article in the Wall Street Journal about the risks faced by certain Indian casinos, and of course although the figures indicate bankruptcy robustness for both casinos in terms of cash flow production, no Indian casino has ever actually gone through the Chapter 11 process. However, I will say that my opinion is that no stakeholder in an Indian casino has any interest in seeing a liquidation. Mohegan has several series of publicly traded debts which at the time I recommended them at the beginning of September of 2010, ranging from around 60 to 80. Since then the price has finished up about five cents up for each issue. As for River Rock, the bonds were at 84 when I recommended them, and after the article was written the bonds were briefly catapulted up to 96, although the spread widened to a whopping eight points (I can’t help but feel partly responsible). The bonds have since settled around 90, perhaps owing to a downgrade from B+ to B-. However, I think that both of these issuers have every potential of being paid off at par and are likely not to lose any significant amounts in bankruptcy. Therefore, these bonds at least remain attractive.

So, although it is difficult to tell anything for certain based on a year and a half of market conditions that were unusually unusual, I think this is a useful exercise to determine what techniques of value investing have worked and which play well with my toolbox of approaches. I will definitely have to do more of these reviews in future.