On a Possible Cause for JRN’s Undervaluation

I thought a discussion of the possible causes of Journal Communications’ undervaluation by the market might help us find other similarly undervalued stocks. In the Gannon on Investing Podcast: “Why Small Caps” I stated that undervalued stocks usually suffer from either contempt or neglect. JRN suffers from both.

Journal Communications (JRN) is a relatively small company, despite the diversity of its media assets. The company owns a collection of low profile media assets. The same size company with a well known flagship would not go as unnoticed by investors. Although the Journal Sentinel is a big paper, I don’t believe most investors know the name. Of course, most daily newspapers are only known in and around the city in which they are published. That brings up another possible cause of JRN’s undervaluation. Perhaps the location of the company’s assets has helped it fly under the investing public’s radar.

Maybe. But, I’m not so sure. All of those factors could contribute to the lack of interest in JRN. However, I doubt they are the primary cause.

One of the best possible explanations for JRN’s undervaluation is the company’s lack of debt. Journal Communications is not debt free; however, for a media company, it is very lightly encumbered. Actually, the company also has a low debt load relative to the S&P; 500. But, I want to focus on the company’s debt relative to other media companies, particularly other newspaper publishers, because I believe that is a key cause of the undervaluation.

The stock market doesn’t totally ignore debt. However, it sometimes fails to fully account for the differences in debt levels between companies. In general, unduly leveraged companies are punished by the market. All other things being equal, the stock of such companies trades at a lower P/E ratio. In this way, the stock market does account for debt.

However, punishing companies with a lot of debt is not quite the same thing as rewarding companies with very little debt. That’s where mispricings can occur. Some businesses in exceptional financial condition are not awarded the premiums they deserve. Such businesses are better able to make acquisitions, buy back stock, increase dividend payments, and weather tough times. Just as importantly, they also have the capacity to take on more debt.

On occasion, I have read the argument that excess cash on the balance sheet may be a bad sign, because it suggests management is not running the business in the way that would best maximize returns on equity. It is true that some companies have more cash and less debt than would be best for the maximization of shareholder returns. However, from this, it does not necessarily follow that such companies are less desirable investments.

I have touched on enterprise value a few times before. There is a reason for this. A business’ enterprise value is a better measure of price than its market capitalization. Generally speaking, a company’s cash can be treated as a reduction to the price paid …

On Newspaper Stocks (Again)

I’m pessimistic about newspapers. But, that doesn’t mean I’m opposed to buying newspaper stocks. The two most interesting offers from Mr. Market are for Journal Register Company (JRC) and Journal Communications (JRN). Expect a write – up on each soon.

There was a recent piece on Journal Communications over at the Motley Fool. Mr. Simpson thinks JRN should dump its telecom business. I have to agree. In fact, I’d like to go a step further. Why not split the whole thing up? The parts are worth more than the whole. So what if it the company isn’t big? It’s cheap, and the value is in specific local assets that could be run just as well if each business was spun off, or if the different businesses were sold to a few bigger companies. There’s value in JRN. Separating the telecom, TV, radio, and newspaper assets should make that value obvious.

I don’t expect it to happen. For now, the value isn’t obvious. That means it’s a good time to dig into JRN. We might just find a bargain.

On a separate note, most newspaper stocks don’t look insanely cheap if you assume decreasing revenues (which I do). The big names may not be your best bet here.…

On an Interesting Experiment

Today, I’d like to invite you to join me in an interesting experiment. To test the importance of focused investing and both its positive and negative effects, I’ve decided to set up five simulated funds with varying restrictions and see how they perform. There’s a site that allows you to do this sort of thing called Marketocracy. I can’t yet vouch for the service, but it’s free.

I’m more interested in testing my funds’ performance against each other than I am in testing their performance against the markets. The restrictions to be tested are:

1. A Home State Fund (only invests in companies headquartered in one’s home state – mine is NJ)

2. A Top 20 Ideas Fund (spreads assets evenly over one’s top 20 ideas)

3. A Top 100 Ideas Fund (spreads assets evenly over one’s top 100 ideas)

4. An Over 10b Fund (only invests in companies with market caps > $10 billion)

5. An Under 1b Fund (only invests in companies with market caps < $1 billion)

If you want to see examples of these funds, you can view my five creations: Jersey Fund, Sniper Fund, Shotgun Fund, Goliath Fund, and David Fund.

I hope to create five groups on Marketocracy that will allow us to track each type of fund and discuss the difficulties caused by these limitations. All funds should also meet Marketocracy’s compliance rules.

I hope some of you will join me in this experiment. We might learn something.

(I know there are readers outside the U.S., for you the Home State Fund will simply be a Home Country Fund. This isn’t a huge advantage, remember some U.S. readers could be from states like California – so, they’ll have a big economy to play in too.)

You can start by joining any or all of the first three clubs:

Home State Funds

Top 20 Ideas Funds

Top 100 Ideas Funds

(I will set the other two clubs up as soon as Marketocracy gives me permission to go beyond the three club limit).

You need to be invited to join these clubs. Anyone can get an invitation by sending an email to: [email protected] asking for an invite. All readers will be welcomed.

You can also request an invite from inside Marketocracy.

Please tell me what you think of this idea by commenting to this post.…

On Energizer

Energizer Holdings (ENR) owns two of the world’s great brands: Energizer and Schick. Currently, about 70% of the company’s sales come from the battery business and 30% come from the razor and blades business. International sales (from both businesses) account for almost exactly half of all sales.

Energizer’s acquisition of Schick was a steal. In 2003, the company bought Schick – Wilkinson Sword from Pfizer (PFE) for just under $1 billion. In 2005, Schick contributed just under $120 million in profit. This figure does not properly allocate certain shared costs to Schick; but, it does include depreciation expense in excess of maintenance cap ex. Therefore, I believe $125 million is a good estimate of the true economic benefit provided by Schick in 2005. Over the next few years, further margin improvements are likely at Schick; because, between product launches, fewer razors and more blades will be sold. Energizer’s cost of capital for the Schick acquisition was very low. Most of the purchase price has been refinanced as fixed debt carrying an interest rate of less than 5%.

Over the next thirty years, Energizer will become primarily a razor business and primarily an international business. When looking at Energizer today, this fact is difficult to see; however, it is an important truth. Here, I disagree with many other commentators on Energizer’s business. They are far more optimistic about the battery business and far more pessimistic about the razor blade business than I am. We both have access to the same information, so why the disagreement?

I believe Energizer’s highly profitable battery business will slowly wither away. It will remain in some form. Even decades from now, there will still be Energizer batteries sold all over the world. But, how many will be alkaline batteries?

A lot of analysts note that Energizer is particularly well positioned in the markets for lithium and rechargeable batteries, and therefore believe a transition to such batteries would not necessarily spell doom for the little pink bunny. Energizer’s sales of these products has recently been growing at a 20% clip. With so many personal entertainment devices finding their way into consumers’ hands (and under their Christmas tress), it looks like Energizer has a wonderful growth opportunity to exploit.

Unfortunately, that’s not how I see it. Energizer will look to grow its sales of lithium batteries – as it should. But, don’t let the flashy growth fool you. There are two parts to the growth factor equation: growth and profitability.

Lithium batteries are unlikely to be anywhere near as profitable as alkaline batteries. They are more durable and less visible. This is a deadly combination for the likes of Energizer and Duracell. A battery that is bought by the manufacturer rather than the consumer is not something these companies look forward to. There is very little price competition in alkaline batteries. Energizer’s brand name and its distribution system is the key to its ability to charge high prices on alkaline batteries. Those advantages are …

On the Free Cash Flow Margin Method

There are several ways to value a business. Investors often disagree on which to use.

I’ve already mentioned using a DFCF analysis based on a free cash flow margin estimate and a sales estimate for a series of years. I used this method explicitly with Overstock.com (OSTK) and implicitly with Lexmark (LXK). Before reading further, you may wish to review those two examples: “On Overstock” and “On Lexmark”.

The free cash flow margin method has several important benefits:

The analyst needs to focus on only two things: revenue growth and the free cash flow margin. The estimate of the free cash flow margin can be based on quantitative data such as the company’s historical FCF margin, the industry’s historical FCF margin, or gross margins within the business. It can also be based on qualitative data like the variability in those margins, the ability of the business to raise prices in a period of inflation, the nature of competition within the industry, and the company’s competitive position. In cases in which the FCF margin has been consistently and extraordinarily wide or narrow, the quantitative and qualitative data will likely agree.

The analyst is forced to make his assumptions explicit. By using exact projections of sales and the free cash flow margin for each year, the analyst is forced to see just how reasonable or unreasonable his assumptions are. Static multiples and simple equations based on a company’s growth factor let the analyst arrive at a valuation without necessarily knowing what his projects for any given year are.

When projecting growth rates into the future, it is very easy to overlook the cruel realities that mitigate the continuance of any trend. Both static multiples and DFCF calculations based on returns on capital and growth rates will often lead to projections of unachievable sales numbers. You may think you are being very conservative in your growth projections for Google (GOOG); however, when you look at the actual revenue needed to support your valuation, you may find you are assuming far more than you thought. That is why I went over the resulting revenue numbers in the Overstock analysis. I wanted to demonstrate that the revenue growth assumptions were not unreasonable, even going out thirty years.

The factors that determine a business’ free cash flow margin are the keys to understanding, and properly valuing, that business. In coming up with an estimated free cash flow margin, the analyst must ask questions about the nature of competition in the industry, the relation of tangible assets to intangible assets, the profitability of the business, the capital spending required to maintain that level of profitability, the stickiness of a business’ customers, the differentiation of its products, and the business’ ability to raise prices. These are important questions. They need to be asked regardless of the method of valuation used. So, why not use a method of valuation that is inherently focused on these crucial questions?

The free cash flow …

On an Interesting Idea

The New Wall Street’s latest post contains an interesting idea – please check it out.…

What Would Buffett Do?

A while back, there was an interesting post on Shai’s blog about Warren Buffett’s assertion that he could achieve 50% returns on $1 million. This, among other things, got me thinking about how Buffett would invest if he were in the position most of you are. What would he do as an individual investor with a small enough amount of capital to invest that it was really no hindrance?

There are several sources we could use to guess what Buffett would do in your shoes. He has invested some of his own money since taking control of Berkshire, and some of these positions are known publicly. Maybe I don’t watch Buffett closely enough, but I doubt these reports give us a good idea of what Buffett would really do if he were in your shoes.

Buffet ran a partnership before taking control of Berkshire. We could glean something from what’s known about his activities then. But, I don’t think that’s necessarily the best guide either. From what I can tell, the partnership’s holdings were more diversified (in the early years at least) than I suspect a modern Buffett portfolio would be.

I think the right answer is small caps. Buffett’s admitted as much at times. If he didn’t have all that capital to deploy, he’d be looking for the most obviously inefficient pricings – that’s small caps. It has to be. The sheer number of really small publicly traded companies guarantees that’s where the best bargains will be. Small caps are the best place to take advantage of a detailed knowledge of each company. A lot of funds are spread so thin; they can’t have even read all the 10-Ks that well. Several of Buffett’s early purchases seem to echo Graham’s Northern Pipe Line purchase. They involve buying shares in a business for assets that are unrelated (or not necessarily related) to the main line of business. Another similar tactic is buying a business for cash flows (including future working capital reductions) that can be diverted into a more lucrative area (like securities). That’s what led Buffett to Berkshire.

These kinds of opportunities are very rare outside of small cap stocks. If, for instance, a major retailer was, year after year, taking all its free cash flow and using it to buy its leased properties, make early repayments of its mortgages, and buy back stock, people would notice. It would be obvious you weren’t really paying for a business that operates a chain of stores – you were paying for real estate holdings. In small caps, this kind of thing can and does happen. Granted, it doesn’t happen a lot. But, it happens more than enough to create a portfolio based on these kinds of situations.

You really can find businesses that have the majority of their assets in something that isn’t strictly necessary to continue the business. For instance, there are small cap retailers who own almost none of their stores and there are small cap retailers who …

On Overstock (Again)

There is a good post over at The New Wall Street entitled: “Overpriced Overstock”. The post makes the case that Overstock.com (OSTK) is headed towards bankruptcy. I encourage you to read it.

Of course, I also disagree with it. Actually, I disagree with the conclusion reached. I don’t disagree with some of the reasoning used to reach that conclusion. For instance, I have visited Overstock’s website, and I do view it as poorly designed, intimidating, and just downright overcrowded.

I also agree that Mr. Byrne’s time could be better spent. However, I don’t agree with one statement:

“I would immediately sell any company whose President spends his time making excuses rather than seeing through the execution of his business plan”

There are two problems here. One, most CEOs of public companies make excuses in their public statements. I was just reading the annual report of a consumer products company that gave “electoral uncertainty” as one of the reasons for a “challenging environment” in the U.S. in 2004. Apparently, a close Presidential election keeps people from shopping.

Two, I don’t see evidence that Dr. Byrne has been doing any of this rather than seeing through the execution of his business plan. I think Overstock has been run according to that plan, and I think that plan is working, as I will explain below. All in all, I can think of candidates for the top job who are a lot worse than Dr. Byrne. In fact, I have had the pleasure of investing in businesses run by such men. My experience was rewarding enough, whenever their stock was cheap enough.

I don’t believe Overstock’s business plan is flawed. In fact, over the past two years or so, I believe Overstock has generated sales in excess of necessary associated costs. Most people will dispute this assertion. It is not borne out by GAAP. Even management’s own financial data suggests sales were below necessary associated costs in a few of these quarters. I think that has to do with the timing of certain expenses more than anything else. I believe sales are already ahead of variable costs, and are growing fast. That’s the formula for future profitability.

It will be interesting to see what Overstock reports for the fourth quarter, because, for Overstock, the Christmas shopping season is a little different from the rest of the year (as it is for many retailers).

The post at The New Wall Street also argues that Overstock is competing with eBay. I don’t believe this is true in any economically meaningful sense. I’ve discussed this kind of competition before, and will be discussing it in my upcoming podcast.

Overstock and eBay (EBAY) are listed in the same industry. I’m sure the management of each company thinks of the other company as a competitor. Still, I’m not convinced there’s much competition going on. The real sales potential for Overstock has nothing to do with eBay. The online retailing market is big enough to …

On Technical Analysis

This piece was prompted by a recent post on Value Discipline. I suspect it will be of little interest to most readers. It is a long, plodding piece that contains two extended quotes from dead men. However, if you are interested in the discussion of technical analysis and value investing, you may wish to read it. In either case, you will want to read Value Discipline’s shorter and more interesting post.

Let me first say that I do not now engage in technical analysis; nor, have I ever engaged in technical analysis. I do not believe doing so would be a productive use of my time.

Having said that, I do not claim technical analysis has no predictive value. In fact, I suspect it does have some predictive value. The Efficient Market Hypothesis is flawed. It is based upon the (unwritten) premise that data determines market prices. As Graham so clearly put it in “Security Analysis”:

“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said. Graham had a very broad mind, much broader than say someone like Buffett. That’s both a blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other works), Graham can not help but explore an interesting topic more deeply than is strictly necessary for his primary purpose. In this case, Graham could have said what many have since interpreted him as saying: in the short run, stock prices often get out of whack; in the long run, they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say that. Instead he chose to describe the stock market in a way that should have been of great interest to economists as well as investors.

Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection is caused in part by the original data, but that does not mean the reflection is an accurate representation of the original data. To take this metaphor a step further, the Efficient Market Hypothesis is based on the idea that the original image acts on the mirror to create the reflection. It does not recognize the unpleasant truth that one can interpret the same process in a very different way. One could say it is the …

On Friday’s Price Drop

Prices on stocks were reduced Friday, making them slightly more attractive. Sadly, many of the biggest price reductions were among the most expensive issues. For instance, Google’s stock price dropped by almost 8.5%. But, we’re still talking about a hundred billion dollar company. Google (GOOG) is trading at something like sixty times next year’s earnings.

Based on yesterday’s news, you might think all stocks had gone on sale. Sadly, that’s not the case. For instance, shares of Village Supermarket (VLGEA) will now cost you about 2.5% more than they would have on Thursday. However, some other companies I mentioned did go on sale:

Overstock.com (OSTK) fell 3.16%

Posco (PKX) fell 3.01%

Journal Register (JRC) fell 2.84%

Home Depot (HD) fell 2.69%

Energizer (ENR) fell 2.43%

American Eagle (AEOS) fell 2.29%

Gannett (GCI) fell 2.03%

It’s always tempting to take a new position at a time like this. But, remember, even among the hardest hit issues, Friday’s price decline was small compared to the margin of safety required for an intelligent investment. I’m only mentioning Overstock, Posco, Journal Register, Home Depot, Energizer, American Eagle, and Gannett, because they already looked promising. Gannett makes the list more because it’s a well known name than for any other reason. Despite the higher debt levels, Journal Register looks more attractive than Gannett, because of the type of properties it owns.

Some of these stocks are more attractive than others. Generally speaking, the stocks at the top of the list look like better bargains than the stocks at the bottom of the list. Perhaps, that’s an indication of investor sentiment. Already out of favor stocks get knocked down even more. Personally, I think it’s just a coincidence. For instance, I thought Jakks Pacific (JAKK), Blyth (BTH), and Timberland (TBL) already looked cheap. On Friday, Jakks and Timberland were up a bit; Blyth was basically unchanged. I suppose asking for a further drop in stocks that are already that cheap is asking for too much.

By the way, Overstock.com is now at a fifty – two week low; Journal Register is at a five year low.

On a personal note, I have to admit Friday’s trading has reinvigorated me. Bargains don’t grow in the sun, and judging by yesterday’s media coverage, there’s a renewed chance of clouds. Still, Friday’s trading didn’t make stocks materially cheaper. A drop of two or three percent is little more than a rounding error.

At least we won’t have to hear about Dow 11,000 on Monday.

Happy Hunting…