Metropolitan Health Networks (MDF): There’s a reason it’s cheap

Current Price: $4.41
At first glance, Metropolitan Health Networks looks like an appealing small-cap value investment. Currently P/E is only 7.12 despite revenue growth averaging more than 60% per year over the past three years. There’s no debt, and cash on hand exceeds total liabilities. It sounds nice – so, what’s the catch? Is this just getting beaten down by unease over future healthcare changes in the U.S. or is it a ticking time bomb? More like the latter than the former, unfortunately.

The Catch, Part I (Earnings)

2010’s earnings growth is largely an illusion. The first sign comes from a comparison between net income and operating cash flow. It’s generally considered a negative indicator when income exceeds operating cash flow and in this case operating cash flow ($18M) is 30% lower than net income ($25.7M). That’s a big turnaround from the previous year, when operating cash flow ($20.4M) exceeded net income ($14.4M) by 40%.

Almost all of the change comes from a single payable/receivable account: Due From (To) Humana. This account jumped from a $1.4M liability in 2009 to a $9.1M asset in 2010. A value in the low millions is a historically normal value for this account; a value of $9M is quite high. As far as I can tell that’s the highest it’s been in a very long time, which makes me wonder if MDF is getting a little too aggressive in its revenue recognition.

The 2004 and 2003 figures are adjusted from the stated receivable values on the balance sheet (which themselves were net of $2.9M and $2.5M allowances) by Humana’s stated shares of 73% and 83%. The collection of this receivable is not guaranteed despite the company’s close relationship with Humana. An example of this occurred in 2006, when MDF wrote off $1.6M out of $4M originally due for the reimbursement of defibrillator implants. If the same occurs again – a distinct possibility since this account is unusually bloated – then future earnings could take a significant hit. The note regarding the amount owed by Humana (note 6) is two lines long and quite uninformative in this issue.

The “Major Customers” segment reveals that part of the receivable comes from an estimate of the retroactive Medicare Risk Adjustment capitation fee. The MRA is the result of changes in the health status – and therefore fee payments covering – Medicare users. In 2009, the company wrote off $800K after the retroactive fee came in below estimates ($3M versus an estimate of $3.8M). The current estimate for 2010’s fee is $2.2M.

The second sign that this extreme earnings growth might be illusory/unsustainable is the company’s extremely low – historically low, in fact – medical expense ratio (MER). The MER is total medical expenses divided by revenue. According to MDF, 2010’s decline in medical expenses is the result of the modification of plan benefits and co-payments along with the elimination of certain costly high risk plans. Compare to their results since 2003:

This is by far the lowest MER has been during the entire period. Operating expenses, on the other hand, increased from 5.4% to 6.7%. Adjusting 2010 to the average MER of the previous three years provides a net margin of 3.68% (after subtracting a MER of 87.4% and expenses of 6.7% with a 38.2% tax rate) and net income of $13.55M. That’s below 2009’s earnings even with the (tax-adjusted) profits from the HMO sale subtracted out for comparison. Due to the increase in other expenses more than 100% of this year’s gain can be attributed to the improved MER.

The changes in MER aren’t attributed to one-time non-recurring events, but if management was capable of sustainably achieving such a significant reduction in expenses – raising profits almost 80% on a 4% gain in sales – by simply altering benefits and removing expensive plans, then what took them so long? It’s not like there’s been a change of management lately.

Let’s examine what happens if the MER rolls back to the median between 2009’s and 2010’s values, 85.3%, if all else remains the same.

Suppose revenue increases by 4% again in the coming year. This results in revenue of $386.6M and net income of $19.1M using the above margins. That’s a disappointing step down from 2010’s results. Even if the company returned to 2009’s lower operating expenses in this scenario it would still slightly underperform the results of 2010, with net income of $24.1M.

The Catch, Part II (Concentration)

The receivables issue highlights MDF’s close and potentially dangerous relationship with Humana. Humana is Metropolitan Health Networks’ sole partner and is tied to it (for the most of their business) by a contract renewed yearly. Any disruptions in this relationship would be disastrous for MDF. As they note in the 10-K’s “Risks” segment, MDF has little ability to effectively bargain with Humana, presumably due in part to their dependent position. Compare their situation with that of Continucare, a publicly traded competitor mentioned in their annual report. Continucare has relationships with three HMOs, decreasing the dependence on any single partner.

25,000 of MDF’s patients are covered under an annual Humana contract, while 9,000 are covered under a separate agreement that lasts until 2013. According to the terms of both contracts the company is specifically restricted from forming relationships with other Medicare Advantage providers. This limits MDF’s ability to lower its immense concentration risk.

The long-term 9,000 patient contract also provides limited security. It does reduce the yearly renewal risk, but it doesn’t cover enough patients to ensure profitability in the absence of other revenue. As MDF points out, even if its other contract was not renewed it would still be required to treat the remaining patients and it would likely be doing so at a loss after fixed costs were spread across a smaller base.

The Catch, Part III (Regulations)

A number of upcoming changes to Medicare and other healthcare regulations due to recent healthcare reforms may have an unpleasant effect on MDF’s business. Risk scores, which determine the amount of money paid per Medicare patient, will be adjusted downward in the future to account for the fact that insurance companies and healthcare providers tend to emphasize negative information when reporting information to inflate risk scores and receive larger payments. Other changes will cap cost-sharing and decrease payment benchmarks.

What looks to be the most important change is the creation of a minimum MLR of 85% starting in 2014. MLR is the medical loss ratio, the percentage of insurance premiums spent on direct medical expenses.

Now, since MDF is a provider services network rather than an insurance company like Humana, I’m not entirely certain which company this cap will specifically apply to. Either way the result won’t be good for MDF. If it applies to Humana, then the two companies must split the 15% (maximum) for non-medical expenses. If it applies to directly MDF, then it means that 85% would be the minimum MER value in the future. In either case the current MER is probably not sustainable long-term in light of this regulation.

The Catch, Part IV (Boardroom Drama)

There have been strange goings-on at the higher levels of MDF over the past few years. In 2009 Earley agreed to step down as CEO and Chairman of the Board in the middle of 2010 or upon the appointment of his successor. Two months before the end of his tenure 5 independent board members resigned and their replacements re-hired Earley as CEO and Chairman. That’s a somewhat odd chain of events and the matter-of-fact description in the annual report (as if this weren’t an odd situation) is a bit unnerving.

Insiders – among them the CEO and CFO – have also been doing a lot of selling recently. I generally agree with Peter Lynch that a modest amount of insider selling aren’t necessarily a bad sign. Insiders can sell for a variety of reasons, some of which are benign (funding a fancy new home/Ferrari collection) and some of which are less so (fleeing an impending collapse). Modest is a key word here, and insiders at MDF haven’t been all that modest with their sales. Over the past 6 months, they’ve collectively made 23 substantial sales totaling almost $2.6M. Extend the timeline to a year and those numbers increase to 35 sales totaling almost $4.5M. The CEO and CFO unloaded $1.5M worth of stock between them during the past year. There were no insider purchases during that time period, despite the fact that MDF at times traded in the $3 range during that period.

Put it all together and there’s too much uncertainty in MDF’s future. There’s no financial integrity since the business is dependent on a single annually renewable relationship and earnings, the main driver of the company’s value since it sells at a large premium to book value, are unstable and possibly a bit inflated at the moment. Definitely not a buy, and as a value investor I’d close out the position if I owned it.

Insider trades: here
10-K: here
Financial Statement Comparisons: here

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Imation (IMN) Analysis

Current Price: $10.83
Imation is a distressed manufacturer of storage media that sells at a sufficiently depressed value to provide investors with an option-like payoff. The core business is low-margin and slowly contracting, which has contributed to the company’s financial woes and a 75% collapse in its stock price since 2007. This price decline, combined with its immense financial stability, creates the option-like effect. It is unlikely to trade below liquidation value but possesses many tools to affect a modest turnaround.

Financial Integrity and a Margin of Safety
Imation offers investors acceptable protection on the downside, especially given the company’s current distress. Downside can be examined from two perspective: financial integrity and a margin of safety. The first – crucial for examining a distressed business – determines whether the company possesses the financial resources to continue as a going concern and the second determines whether investors are buying in at a sufficient discount to fair value.

Imation’s ability to continue as going concern is beyond question. Imation currently has no long-term debt or significant off-balance sheet liabilities, only a relatively minor purchasing commitment with flexible terms. The company has a substantial store of cash: $300M against a market cap of $420M. That stockpile has been built up through consistent free cash flow production, even in years of substantially negative earnings ($143M/$56.5M/$71.1M in 2010/2009/2008 respectively). Consistently positive free cash flow means that IMN does not require infusions of cash from the capital markets to fund expenditures, acquisitions, or simple survival.

Stability is aided by the business’ low capital expenditure needs. Even in 2008, before cost-cutting and efficiency measures began in earnest, capital expenditures were only $20M. Current capital expenditures are lower still and even at/above 2008 levels they are much lower than combined depreciation and amortization expenses. Management has announced plans to increase expenditures in 2011 as part of their greater restructuring plans, but even a 100% increase from 2008’s capex would be covered by projected cash flows (see below).

The margin of safety here comes from the substantial discount to book value. Currently the P/B ratio is only .53. This discount is so significant that even if all of the company’s intangible assets (valued at $320.4M) were written off immediately it would still trade at a discount – albeit a smaller one – to that impaired book value.

The discount is also significant enough that IMN is trading near a rough estimate of its liquidation value (assuming a relatively orderly liquidation rather than a fire sale because the company is not in immediate distress):

This acts as a soft price floor for IMN, since it is unlikely to continuously trade below its liquidation value. The company could potentially impair its liquidation value through poor performance or unwise acquisitions, but as you can see below IMN would require extraordinarily poor performance to seriously impair its liquidation value. Most of its liquidation value is derived from current assets, so another round of restructuring charges would do little to impair its value and only truly severe losses could even moderately deplete its store of cash. Bad acquisitions are still a potential issue and something to be watched after, but since management’s largest hypothetical target would be in the $50M range that would only be a 12.5% loss even on a completely worthless acquisition.

Cash Flows
Imation currently sells for wildly low Price-to-Cash Flow multiples: P/FCF of 3x and an EV/FCF only slightly over 1x (and that assumes that $50M in cash is necessary for the business). Alas, these valuations are temporary and driven by the substantial increases in working capital efficiency over the past three years. Although management no doubt would like to extend their successes further, it is unrealistic to assume that efficiency gains will continue.

Here is a slightly more modest set of  rough projections:

These projections are not meant to be predictive, only illustrative. They provide a sense of what effect different outcomes might have. Maintaining the status quo as in scenario A means another 10% decline in revenue, keeping gross margin flat, raising R&D 30%, and seeing SG&A rise to 14.5%. Scenario B provides an idea of how income/cash flows might look if IMN’s fortunes began to improve in 2011. Here revenues again decline 10%, but the gross margin is 2010 gross margin adjusted for the $14.2M inventory write-off. This scenario also shows the impact of flat SG&A and modest improvement in working capital management. The third scenario shows the impact of a lower gross margin (15%), lower revenues (declined 15%), and additional restructuring charges due to the continued poor performance.

Scenario B illustrates that management’s goal of shifting resources towards their higher margin products could return IMN to profitability with only a small improvement in gross margin. Scenario C, while not a full-fledged disaster scenario, illustrates that a true disaster rather than a simple bad year or accelerated decline would be required to impair the company’s liquidation value.

Future Developments and Valuation
The ambiguity about the future is key to the option-like nature of IMN. In the face of large paper losses and future uncertainty investors have deserted the company in droves over the years and driven the price down to the point where it becomes appealing for conservative investors.

There has been insider selling but only from Linda Hart, the non-executive chairman of the board. Her sales could be construed as a lack of faith in IMN, but it seems more likely that the sales are tied to her impending retirement from the board of directors in May since none of the other directors – who are privy to the same information – are currently selling.

Management is relatively clear about what it intends to do (switch IMN’s focus to its higher-margin products like secure storage), but the difficulty in accomplishing that task seems off-putting to some. The company’s market value certainly indicates an enormous amount of pessimism. Currently IMN’s enterprise value is roughly $150M (depending again on one’s definition of “excess” cash), implying that investors believe it has almost no ability to succeed. Assets are valued by the cash flows they can produce and investors consequently attach little value to its assets – only $.50 on the dollar – because they appear to be unable to generate positive returns. If the situation changes P/B will rise accordingly. Even a 50% rise would only leave IMN with a P/B of .8, which is still a relatively pessimistic bottom-quartile valuation. A turnaround of this nature takes time, so this matrix breaks down annualized returns based on valuation and time span:
In the event of a turnaround, only modest returns are needed to provide an investor with a double-digit rate of return over a multi-year period. If the company remains stagnant, then liquidation value limits the potential downside.

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OM Group (OMG) Analysis

OM Group appeared on my radar as a potential value investment when I was looking for large companies selling below book value. OM Group currently sells at an appealing discount (P/B is .8) and has plenty of cash: $400M against debt of $120M and a market cap of roughly $1B. There’s a catch, though – too many off-balance sheet risks/balance sheet oddities and no chance that the cash will be returned to shareholders any time soon.

To me, the first red flag is that the company’s primary source of cobalt, a critical raw material, is located in the DRC and operated in a joint venture with Groupe George Forrest (25%) and Gécamines (20%), a state-owned entity of the DRC. The wikipedia entry is here, but suffice to say that the country’s overall history can safely be classified as “sad” and (key point) its stability is tenuous. Judging by

The other partner, GGF, was the beneficiary of a loan from OMG to refinance its capital contribution. Of the remaining $19.1M owed to OMG by Groupe George Forrest, $5.2M has already been written off, with the remainder guaranteed by the partner’s returns on the joint venture. First off, it’s a bad sign that there’s already a valuation allowance for 20% of the value of the loan. It also strikes me as somewhat paradoxical collateral: GGF primarily deals in metals, so if price changes of raw materials leave GGF strapped for cash then it’s possible that the joint venture might be experiencing similar price pressure, making it unable to cover the loan.

As an addendum to this risk, the company’s $68.1M “restricted cash” asset is actually money held in trust pending the outcome of a lawsuit against GTL, the joint venture company. The company (of course) assures shareholders that they expect everything to be fine and dandy. Since company’s rarely feel the need to draw attention to potentially crushing losses, I’d view their optimism with a bit of skepticism.

Regarding the balance sheet, there is also a disturbing jump of “Other Current Assets” from $32M in 2009 to $44M in 2010. Most of the increase – most of the account itself, actually – is not adequately accounted for anywhere in the 10-K. Derivatives, deferred income taxes, and the recent acquisition of EaglePicher Technologies account for perhaps 25% of that total and the rest remains a mystery. In “Financial Shenanigans” (great read, by the way) Howard Shcilit mentions that companies can inflate earnings by capitalizing costs and lumping them under the heading of “Other Current Assets” and a suspicious mind might question whether the same thing is occurring here.

OMG (I’m starting to feel silly typing that…) also has more customer concentration than I like to see. 50% of its battery sales go to three customers. That’s not quite ruinous concentration – they’ve got other business lines, after all – but it’s more than I like to see with all those other questions floating around.

Just to top it off, most of the cash (87%) is held overseas and will remain there for tax reasons. The company has explicitly stated that it will not pay dividends and it doesn’t seem particularly interested in buybacks either.

Other, more quantitative measures of value are more forgiving – low level of debt, decently low valuation relative to its free cash flow – but all of the concerns above suggest that the company’s financial integrity and asset quality are a lot more questionable than simple financial ratios and earnings multiples let on. I’ll pass.

Current Price: $34.13
Latest 10-K:

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Speedway Motorsports (NYSE: TRK) Analysis

Current Price: $14.52

Speedway Motorsports is the owner/operator of nine race tracks used primarily for NASCAR events. TRK and International Speedway Corporation (NYSE: ISCA), the other major player in its business, together own the majority of the tracks used for major racing events in the US. The recession and a decline in NASCAR’s fanbase have eaten into both companies’ profits, but they have no realistic challengers within their industry and would benefit greatly from any expansion of consumer spending. TRK is by far the more attractively priced of the two, selling at a substantial discount to both its present net asset value and its historical P/B valuation.

Industry and Company Background
Between them, TRK and ISCA own 21 of the 29 tracks used by NASCAR (nine belong to TRK, twelve to ISCA). Most of the other tracks are individually owned by separate companies or by the smaller competitor Dover Speedway (NYSE: DVD), leaving TRK and ISCA with a duopolistic domination of the industry. Construction of new and competing tracks would require a substantial capital investment as well as the development of a sufficiently strong relationship with NASCAR to convince it to transfer existing events to a new site. The performance of Dover Speedway, which has lost money in four of the last five years and only rarely achieved a double-digit operating margin, demonstrates the daunting challenge that potential new competitors would face.

Any intense competition between the two leading companies is limited since races are distributed across the country and throughout the year. Operating margins for the two companies hovered in the 30%+ range from 2000 until the recession began to take a toll in 2009, suggesting that they both operate behind a substantial moat and generally do not poach business from each other. Although current earnings are disappointing compared to that history, it suggests that there is substantial upside for TRK when attendance and ticket pricing at its events improve. Investors appear to be pricing in a continuing decline in NASCAR’s overall popularity but much of the year-over-year revenue decline in event revenues in 2009 and 2010 actually came from reduced ticket prices (78% and 49%, respectively) rather than from reduced attendance. This indicates that increased consumer spending – eliminating the need for sales and special promotions – would significantly benefit TRK even without an increase in the fanbase. Broadcast revenues are tied to an eight year contract with four years remaining. Viewership is down 25% since the contract began, which concerns NASCAR, networks, and advertisers alike, but investors have less to fear. Not only has broadcast income remained relatively stable – actually increased slightly – due to annual rate increases within the contract but NASCAR is still the sport with the second highest television ratings (behind football) and plenty of time remains for NASCAR management to win back viewers before negotiating the new contract. Some simple changes could likely be made to great effect like rescheduling its Sunday events to avoid direct competitions for viewers with the NFL, provided management is willing to recognize these problems.

Although ISCA owns more of the iconic race tracks, such as the Daytona International Speedway, it sells at a premium that reflects its relative glamour. TRK currently has a market cap of $605M compared to a book value of $867M. ISCA sells for $1,350M with a book value of $1,187M. Even the chronically troubled Dover Speedway trades at a premium to book value.

The low valuation has two causes. First and foremost, TRK lost $10M in 2009 and only made $23M in the past year on lower revenue. The stock price has been in a steady decline since 2008 – despite strong performance in that year – presumably related to declining NASCAR viewership and investors probably take recent results to mean that those trends will continue. As I mentioned above, however, the competitive dynamics of the industry strongly favor the two major players and I expect profitability to return with time because of the greater role of ticket discounting in the revenue declines.

Second, the CEO, Burton Smith, owns 68.8% of the company. His large stake limits the size that outside investors can take and also prevents outsiders from exercising any say in the company’s affairs. Investors could view this as a negative, since it removes the possibility of takeovers or activist actions, but that hasn’t prevented them from attaching a much higher valuation to assets in the past:

Year 2001 2002 2003 2004 2005 2006 2007
Ownership % 65.5% 64.9% 64.4% 63.6% 63.4% 63% 63.6%
P/B 2.4 2.2 2.3 2.7 2.1 2.1 1.6

Balance Sheet and Assets
Those assets are secure and unencumbered. Speedway Motorsports appears financially sound in the immediate future. Current and quick ratios are 1.67 and 1.46 respectively and have been increasing for several quarters. Debt/Equity is currently .72 as a result of the acquisitions of the New Hampshire Speedway and Kentucky Speedway tracks in 2008. The company does not appear interested in further acquisitions and is in the process of paying down debt.

Outstanding debt is primarily composed of two issues: $330M 6 ¾ notes due 2013 and $268M 8 ¾ notes due 2016. TRK has been reducing long term debt by $10-20M per quarter for the past year and is in the process of making a tender offer for the 2013 notes funded by a new offering of $150M senior notes due 2019. This aids in their ongoing de-leveraging, as much of the tender offer will be funded with cash, and indicates that the company continues to be able to access credit on favorable terms (6 ⅞%, according to speculation cited by Bloomberg).

By and large Speedway’s assets come in two forms: its race tracks and its race event sanctioning/renewal agreements with NASCAR. Both offer tangible sources of value to investors. The latter, though technically intangible, is a crucial part of TRK’s moat and preserves the company’s competitive position. The former provides a source of hidden value. Many of the tracks were acquired over a decade in the past at a significantly lower price than comparable facilities would cost today. The Bristol Motor Speedway, for example, was acquired for $26M in 1996. Infineon Raceway (formerly Sears Point) was leased with a purchase option of roughly $40M in the same year. Charlotte Motor Speedway was built by Burton Smith in 1959 and is the company’s original holding, so it too is likely carried on the books at a substantial discount to its current reproduction value. Figuring a precise reproduction value is complicated by the fact that the potential value of newly-constructed facilities might be somewhat lower than recently acquired facilities (like New Hampshire Motor Speedway) due to concerns about the sport’s popularity. Even so, the extraordinarily steep discount to even a pessimistic reproduction cost for facilities like Bristol or Charlotte suggests that book value probably underestimates true net asset value by at least $100-200M.

Cash Flows and Safety
Investors who fear that continuing declines in NASCAR’s popularity will cause earnings to languish should examine the current FCF production. Even in fairly poor years like 2009 and 2010, TRK had FCF of $95M and $94M (ttm) respectively. That equates to a current P/FCF of only 6.44x.

Free cash flows from the past two years are moderately inflated by lower levels of capital expenditure in the past two years. Management comments in the most recent filings suggest that capex will increase in the coming year as TRK renovates the Kentucky Speedway. The Kentucky Speedway project is the only non-routine capital expenditure that the company has planned and its budget of $60M is spread over several years. With that in mind, capital expenditures should not exceed depreciation in the coming years. Adjusting capex for 2010 (ttm figure) upwards to $50M still leaves a ttm FCF of $62M and a P/FCF of 9.87x.

It is also important to note that the loss recorded in 2009 was the result of a $76.7M impairment charge caused by the failed Motorsports Authentics joint venture with ISCA rather than a steep decline in the core business. The company had an otherwise profitable year. The carrying value of TRK’s investment in Motorsports Authentics is now $0, so there’s no risk of future impairment charges, and MA has renegotiated its license agreements on more favorable terms, allowing it to turn a small profit in the first nine months of 2010.

Speedway Motorsports offers potentially excellent returns to patient, value-oriented investors. Given the company’s strong competitive position and the effect of ticket discounting on revenues noted above, TRK will likely see a return to something approaching its past levels of profitability once consumer spending improves. Since its assets are valued near all-time historical lows there is significant potential for appreciation. In its heyday TRK had an average P/B ratio north of 2x. Coming this close to a recession and with questions about viewership retention, that would be an optimistic target. The five-year average is only 1.2x, a more modest and reasonable goal. Merely achieving 1x would still provide an acceptable return for conservative investors.

Given the uncertainty facing the U.S. economy today, I would hesitate to predict exactly when consumer spending would return to its former levels. Luckily, the mispricing here is extreme enough that substantial returns are offered even if the opportunity takes several years to fully work out:

(with dividends included but not reinvested)

Time Span Starting Value Final Value at P/B 1x IRR at P/B 1x Final Value at P/B 1.2x IRR at P/B 1.2x
1 Year $14.52 $20.64 + $0.40 44.9% $24.77 + $0.40 73.3%
2 Years $14.52 $20.64 + $0.80 21.5% $24.77 + $0.80 32.7%
3 Years $14.52 $20.64 + $1.20 14.6% $24.77 + $1.20 21.4%

Even a protracted workout period with the most conservative target (three years to reach a P/B of 1x) provides an annualized return of 14.6% with a margin of safety provided by TRK’s already substantial discount to net asset value and powerful competitive position. Any of the more optimistic scenarios promise an annual rate of return above 20%.

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Book review: The Aggressive Conservative Investor (Whitman and Shubik)

When I first started reading Martin Whitman’s exhortations about the importance and neglect of assets as a tool of valuation I thought to myself, “But everyone knows that assets are an important tool. Is this really still relevant?”

Then I looked at the front page of Seeking Alpha and saw articles about earnings, about commodities (definitely commodities), and about currencies. Nothing about neglected assets and not a lot about security. It occurred to me that even though Whitman’s been pointing out the excessive primacy of the income statement for around three decades, some things never change. And really, that makes sense in light of Whitman’s own writing.

More than anything else, Whitman emphasizes perspective. As he points out, a lot of people are in the market for a lot of different reasons and investors have to appreciate this when they try to gauge the actions of the market and its participants. Activists have different guidelines for what constitutes a suitable investment than do purely passive investors and short-term traders have a lot more interest in volatility than long-term investors. That isn’t rocket science, but its a simple and powerful observation that a lot of people overlook when speaking of The Market and its irrationality. You see people characterize every transaction in the market as having a winner and a loser, but really the definition of winner and loser depends a great deal on perspective (Richard Bookstaber also sort of gets at this in A Demon of Our Own Design). For those with a long-term perspective – and he actually emphasizes that distinction, rather than denigrating those with other perspectives – Whitman has a lot to add.

Perspective also applies to financial statements. More so than most books on investment, The Aggressive Conservative Investor spends a fair amount of space digging into the subject of accounting and accounting presentation. Again, it’s not exactly news that there are gaps in GAAP, but few books devote as much effort to getting it its core assumptions, uses, and limitations. I think this is one of its most unique and appealing aspects.

I was also struck by the simplicity of his investment approach. The financial integrity approach (re-dubbed “safe and cheap” in his new introduction) has four guidelines:

1. Strong financial position
2. Honest management and control groups
3. Reasonable amount of information available
4. A price below estimated net asset value

Simple, but effective: Third Avenue had the best mutual fund record in its class over the past 20 years with a 12.84% annual return. Granted, Whitman seems to do a lot of his fishing overseas these days, but methods could probably be applied with a fair amount of success within the US market by investors who don’t have the same size constraints as a mutual fund the size of the Third Avenue Value Fund. I’ve heard the style he advocates here referred to as the “good enough” mentality and that’s fitting.

As an amusing side note, Whitman seems to enjoy emphasizing his disagreements with and improvements on the methods of Graham and Dodd. Interviews and online reviews of his other work suggest that’s a constant theme. He also has a love of inventing new acronyms that do little or nothing to clarify his meaning. These quirks, along with his occasionally long-winded writing, detract a bit from the book overall but they don’t invalidate or obscure his points.

This book makes it onto Seth Klarman’s recommended reading list (ironically, the writer at this site hasn’t read it) and with good reason. I’d definitely recommend it to anyone with an interest in value investing (and hey, didn’t you see the recommendation from one sentence ago?).

Full disclosure: I received a review copy of The Aggressive Conservative Investor from Wiley.

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Update: KLIC and MU make me look like a doofus, round 1 goes to James Montier

MU starting price: $7.90 (on 12/30/10)
MU current price: $11.70
Percentage change: 48.1%

KLIC starting price: $7.46 (on 12/17/10)
KLIC current price: $10.04
Percentage change: 34.58%

In an earlier post, I referenced a James Montier article about how people frequently underperform simple quantitative models through overconfidence and a variety of other mental biases. I’ve been too busy working to actually test that as thoroughly as I’d planned, but this makes for a decent first attempt. Both of these companies had qualitative bugaboos on their financial statements that turned me off despite their sound fundamentals and low valuation but, thinking of Montier’s admonition, I decided to keep an eye on both. Lo and behold, both performed spectacularly over the course of two months. This is way too small a sample size to form any real conclusions yet but it made for an eye-opening first experiment and definitely piqued my interest for testing the “quantitative under-confidence” idea further.

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Examining Whitney Tilson’s recent troubles with his NFLX short and the recent realignment of his portfolio  suggests to me a value-based short-selling rule: only short zombie stocks. By that I mean a company that is literally the living dead – a company whose investors/management have not caught on to the fact that the company is already dead on its feet.

I read Kathryn Staley’s The Art of Short Selling and came away thinking that the most important rule in short selling is to never short good companies. Companies like that won’t have impending accounting or legal issues (that’s part of why they’re good companies), so shorts are only based on valuation or belief that there is an impending quality decline. I remember seeing a link years ago to this post about the surprising success of Netflix and it stuck with me. Predicting that a valuation is irrational brings to mind that old Keynes saying about the markets staying irrational longer than you can stay solvent. Being right isn’t enough – you have to be right in a timely manner, lest your investors get frustrated and wander off. This aspect becomes less important if you’re only managing your own money but you need to remain confident in your judgment through bad times (easier said than done…). Not only that, but you need a timely price drop to get a solid IRR since short selling has a natural maximum return – no ten-baggers here.

Even worse, valuation and quality decline shorts assume that the company can’t meet the inflated expectations or solve its potential problems. That’s not a likely occurrence, but if it happens you will suffer permanent loss of capital and you must respect the danger.

To me, the zombie rule is fundamentally about keeping a margin of safety. Value investors want to minimize downside first and foremost (“Rule #1: Don’t lose money”). The way to minimize downside in short selling is to find companies that have no realistic upside. That sounds like it ought to be simple, but it there are a few complications.

Truly embracing a margin of safety means that this rule might exclude the short selling of some companies that have committed accounting fraud. Consider David Einhorn’s battle with Allied Capital: that one took six years to play out. I haven’t read Fooling Some of the People, but I’m guessing the returns on that investment weren’t what you’d call spectacular – he was in it for the principle, not the payoff. Most shorts aren’t going to turn into that kind of half-decade slugfest but it’s important to recognize that some companies are better equipped to wage PR battles in their own defense.

We can look to another of Einhorn’s shorts to see a great example of a zombie stock: Lehman Brothers. There wasn’t simply a wildly optimistic valuation or an impending decline in quality – the combination of leverage and low-quality assets left the company dead on its feet.

About a month ago I wrote up Cagle’s (CGL.A), which looked like it had the potential for zombification due to constantly rising corn prices. So far it looks like that one has come half-true since it posted a significant loss for the most recent quarter and equity now looks to be below the $40M cutoff in its debt covenants. It’s down about 12.5% since the announcement and it’ll be interesting to see where that goes. I think I’ll be revisiting this topic in the future to try to refine specific value rules for short selling.

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