Disclaimer: Walter Lu currently owns EDCI, ADPG, NE, PMIC, MYRX and ADPT in his Covestor Flexible Value Model.
August 30, 2010: There has been a lot of talk recently about a possible double-dip recession. I think many investors are overreacting, not because I think another recession is unlikely, but because most people don’t really know much about the economy and how economies work in general (myself included). The economy is too large and complicated for anyone to fully comprehend. It’s a worldwide complex adaptive system with billions of moving parts. Trying to predict the economy is like trying to predict the stock market.
In contrast, when you are talking about a single company, it’s much easier for some people to thoroughly understand it, like the executives of the company or well-informed insiders. As investors, it’s important to be aware of how economically sensitive your businesses are, but that’s different from forecasting the future direction of the economy. My point is, it’s extremely hard, if not impossible, to make informed decisions based on the economy as a whole. And investors need to realize that when they buy/sell based on their opinions of the economy, they are betting that the economy will actually do better/worse than what the stock market projects. As for me, the stock market knows the economy better than I do, so I won’t make any bets against it in this area. However, it’s much easier for investors to prove the market wrong on individual stocks, so that is what I focus on.
A large chunk of my portfolio is in ATPG and NE, two energy stocks that have been decimated by the BP spill. The thesis for holding these stocks is pretty simple: the risks don’t justify their valuations. Even assuming that the regulatory pressures on deepwater drilling in the Gulf of Mexico intensify significantly (which I don’t believe will happen), the stocks are too cheap.
Noble (NE) doesn’t even do most of its business in the gulf, yet it is selling at about 5 times earnings and close to book value. For a high-quality company with smart management and bright growth prospects, this is a great deal. It’s in a similar position with Transocean (RIG), without the possible spill liabilities. The main risk I see here is possible oversupply of rigs in the market if drilling activity does slow down in a major way, causing day rates to fall sharply. However, at just 5 times earnings, and with low operating and financial leverage (NE has a net margin of over 40%!).
ATPG is riskier but with enormous upside. They have some world class assets, with huge production coming online this year and next. The company is in a transformational stage right now, and their massive investments over the past few years will finally start to pay off. The downside is their horrible balance sheet – they were overleveraged going into the downturn and are lucky to still be around today. But they have almost reached the finish line. And with favorable financing in place, a lot of the risk has already been taken off the table in the near term. In my opinion, they were undervalued in the high teens (it’s trading at around $11 as of August 30, 2010) and did not deserve to get their stock cut in half just because of the BP spill.
However, anything could happen in the gulf, or to oil and gas prices, or the energy sector as a whole. These things are inherently hard to predict. But I think that these stocks are cheap enough so that most outcomes will result in something positive for the stocks. These are relatively high risk, but I believe their potential makes them good bets.
The new positions in the portfolio are MYRX, ADPT, PMIC, and EDCI. All of these stocks are selling under liquidation value, meaning if someone were to buy these entire companies at the current market price and wind up the businesses, selling all the assets and letting the employees go, there’s a good chance they would make out with a nice profit.
In fact, Berkshire Hathaway was originally acquired by Warren Buffett because it was selling for under liquidation value. Though he did not liquidate the company immediately (like some of his previous acquisitions), he did liquidate it slowly in a way, by choosing to not reinvest much back into Berkshire’s textile business, instead allocating capital to other opportunities.
The appeal of stocks like these (known as net-net stocks) is that the majority of their value is derived from tangible sources that can be precisely measured today – cash, securities, receivables, and other liquid assets – rather than from an uncertain stream of cash flows extending decades into the future. This makes valuation simpler, and thus reduces the risk of overpaying, at least in theory.
In practice, there are more risks than apparent at first glance. Companies that trade at such cheap valuations are almost always low in quality. They are in competitive industries, with poor management, and have declining businesses. These are some of the most unpopular stocks in the market. Investors have given up on them, often for good reason. But because of these low expectations, positive surprises are much more impressive to the market than for higher-quality companies, resulting in larger upside.
The main risks in buying such stocks are that the businesses may continue to decline and drain cash, or management may waste all the cash on bad acquisitions and business ventures. Even when all goes well, the discount to liquidation value may not close for a very long time, if it all, resulting in an opportunity cost. In most cases, shareholders of these stocks would be best served if management bought back shares or paid out a dividend, but it rarely happens. Because of this, a catalyst can be very helpful with these types of stocks.
Despite these dangers, historically, such cheap stocks have performed very well, though they are volatile and can underperform for long stretches of time. Many of these businesses eventually fail with nothing to show for their efforts, so diversification is key when investing in this corner of the market.
Here’s a quick overview of the new positions:
MYRX – A small pharmaceutical firm spun off from Myriad Genetics (MYGN) in 2009. It’s trading at a substantial discount to net cash, but burning cash as it develops its drugs. It’s likely that the company will burn through all of its cash before pushing out enough successful drugs to become profitable, which would not be good for the stock. However, the upside is significant if things go their way. It’s a fairly risky play, so the position is small. Some insider buying back in March.
ADPT – A technology company that works with memory and storage. Selling at a moderate discount to net cash. I became interested in this stock because of its catalyst – the activist hedge fund Steel Partners is continuously building a large position in the stock, and it already owns nearly 30% of the company. They have been trying to get management to realize some of the value on their balance sheet, as well as sell parts or all of the business.
PMIC – A small agricultural insurer. Demutualized in 2008. Selling at discount to net current assets, most of which are fixed income securities. Good management with well-aligned incentives. Recently, there has been heavy insider buying.
EDCI – This is a company that is actually liquidating. Unfortunately, the stock did not meet Covestor’s liquidity/size requirements, so the trades were not reflected in the model portfolio. The process is not exactly straightforward, with a few steps involving distributions of cash and stock splitting and reverse-splitting, so it’s possible to play this stock multiple times on its way to being fully liquidated.
Here are the gory details. My first buy was on July 23, 2010. EDCI planned to pay out $1.56 per share in early August, followed by a 1-for-1400 reverse split, with any shareholders owning fewer than 1400 shares being paid $3.44 instead of receiving stock, for a total of $5.00 per share. On July 23, 2010, it was trading for $4.74, so investors could’ve realized a relatively risk-free 5.5% gain in a couple weeks’ time, for a 300% annualized return (if they bought fewer than 1400 shares). This is what I did and it played out nicely for me. Since then, the $1.56 has been paid out but the reverse split has not yet taken place. On August 18, 2010, I bought again for $3.36, anticipating the $3.44 payout, for another relatively low-risk trade (again, with fewer than 1400 shares). Alternatively, an investor could buy more than 1400 shares to receive the final liquidation distribution, which I believe will be higher than the current market price. This would be a higher risk but higher potential trade.
Some stocks I am currently researching: LCAPA, HAWK, AHS, PRGN, ASCMA, FURX, IIG, EMMS, FRD, MRH
