Profiting from Fear

September 28, 2009 by Joe Ponzio

I often tell clients and investors: “If I can find one or two opportunities a quarter, I’m ecstatic.” As we close out the third quarter of 2009 in a few days, I’d like to share with you some of the investments we’ve made. As I mentioned in this post, I simply don’t have the time to maintain an F Wall Street portfolio, but that doesn’t mean I haven’t been investing!

We’ll start with a position taken on July 27, 2009 – Volt Information Sciences. It’s the company to which I alluded in this article, and then mentioned in this comment. Below is the text of an e-mail I sent to clients shortly after I bought the stock. After the text of the e-mail, I’ll provide some thoughts.

Dear Joe,

Today we invested in Volt Information Sciences Inc. (NYSE: VOL, “Volt”), a provider of staffing services and telecommunications and information solutions throughout the U.S. and Europe. Odds are, you’ve never heard of Volt, and a quick look at the business’ performance might leave you scratching your head over this one; so, let me explain.

Remember: We always want you to be as comfortable with your portfolio as we are.

Volt is a very “ordinary” business – thin profit margins in good times, and a very average return on equity under normal conditions. (Average return on equity for American businesses is around 12%.) Over the past ten years, Volt’s revenues have been steadily increasing and earnings, while volatile, have also risen over time. Still, it’s not the next Google.

What is it about Volt that attracts us? Ben Graham and “net-net.”

Net-net: Defined

A “net” is a stock that is trading for less than its “net liquidation value” – its break-up value. You may also know these as the low “price to book” or “below liquidation value” stocks discussed in many value investing books. A “net-net” is a stock that is trading for less than its “net working capital less long-term liabilities” – basically, a company that has so much in cash, accounts receivable, and other “current assets” that it could pay off all of its liabilities (short- and long-term), and still be liquidated for less than its trading value, assuming its properties, equipment, and other long-term assets were completely worthless.

Ben Graham – the father of value investing – discussed these in both The Intelligent Investor and Security Analysis, and Buffett reportedly spent his early years at his partnerships investing primarily in net-nets.

The math behind net-nets is simple, and we’ll illustrate it with our recent investment in Volt.

Volt as a Net-net

Volt’s market capitalization – the price at which we could theoretically purchase the entire company – is about $163 million. The company reported (May 3, 2009) $633.8 million in current assets, which include cash-on-hand, accounts receivable, inventories, and other cash expected over the next twelve months. The company also reported $61.2 million in property, plants and equipment, and another $111.5 million in various other long-term assets, both tangible and intangible.

The sum of the company’s liabilities, both short- and long-term, was $411.2 million.

Temporarily ignoring the roughly $173 million of long-term assets (properties, goodwill, etc.), the company could quickly be wound up in the next year for $633.8 (current assets) minus $411.2 (total liabilities), or $222.6 million – roughly 25% more than the market capitalization – and that’s assuming that the properties, equipment, and all other long-term assets are totally worthless.

Worth More Dead Than Alive?

If Volt shut down today and liquidated in an orderly fashion, we would likely earn more money – probably 15% or so more – than we paid today. And though the market seems to be pricing Volt as if it’s going out of business, we see no reason that it should.

In its fiscal years ending October 29, 2006 and October 28, 2007, the company’s operations generated more than $33 million of owner earnings. For the fiscal year ended November 2, 2008 – a tough year for all businesses – operations generated nearly $24 million of owner earnings. The first six months of this fiscal year which ended on May 3, 2009, the company had negative owner earnings of -$3.8 million – a small sum when compared to its financial and cash position. Its short-term liabilities are well covered and the company has virtually no long-term debt.

Though its earnings have fallen significantly and turned negative over the past two years, this hasn’t caused a rapid cash burn. Furthermore, the company has recorded $14.4 million in impairment and restructuring costs so far this year – costs that are not likely to occur over a long period of time.

Through the worst part of this recession (the first two quarters of this year; still, I wouldn’t break out the bubbly as anything can and does usually happen), the company’s cash burn rate was such that it could reasonably operate under those extreme conditions for more than ten years.

The Margin of Safety

Our margin of safety on this purchase appears to be two-fold:

  • if the company goes out of business, we should get back more than we paid in an orderly liquidation. (Again – we don’t believe there is any risk of it going out of business.)
  • if the company returns to a more “normal” state of operations, its intrinsic value should be more than double what we paid.

We plan to exit Volt at the sooner of:

  • two years,
  • a 100% gain, or
  • a material change in the business that would no longer make its then market price attractive.

A Note on Today’s Price Action

If you bring up today’s chart on Volt, you’ll see that it spiked in early trading on no news. That was us, and it speaks to the ridiculousness of the markets and why prices mean very little.

We placed a large order for Volt relative to its regular trading volume. Though the market maker tried to sneak us in, the market’s speculators – seeing the aggressive buying – also jumped in to ride the Volt trend of the day. Ultimately, I expect them to be disappointed as our early, aggressive buying dried up when the order was filled, and now they are sitting on short-term, trend-trading holdings that they will likely dump at any price, causing Volt to drop and forcing them to take a loss.

That is the nature of the day-to-day markets. The actions of one large investor can affect the actions of dozens or hundreds of smaller investors; and, while every approaches the same stocks with different intentions (long-term holdings vs. short-term trading; 2% daily gains vs. 100% multi-year gains), they all act together to create wild volatility and unpredictable daily price changes.

By not taking our cues/instructions from price changes, we can be much more patient in our approach and have results that may not correlate with the overall markets.

As always, if you have any questions, please let us know.

Joe Ponzio

End e-mail

Going Where the Panic Is

In March of this year, I presented to MBA students at Howard University in Washington D.C. I modified Buffett’s “Be greedy when others are fearful” by summing up my investment strategy as:

The time to invest is when you find an asset surrounded by fear, where the risks of that asset are grossly overestimated.

When it comes to investing, the first question you must seek to answer is: What can I lose? It’s not a question that is answered with absolute precision; but, it can be answered to a certain degree. In this case, the market seemed overly fearful of Volt – an employment company in the midst of rising unemployment – and priced it below liquidation value.

What could I lose? If the company were liquidated in an orderly fashion, I’d expect to earn about 15%. If it survived as an ongoing concern, I’d look for a 100% or so gain. As Mohnish Pabrai put it: Heads I win; tails I don’t lose much or win a little. (By the way, Pabrai’s was a great annual meeting; and, though I’ll write about it soon, Miguel Barbosa at Simoleon Sense posted some notes here as well.)

Could I lose in other ways? Sure! The price could have fallen 50% from our purchase price, and then never recovered because the market never went on to realize Volt’s value. The economy could have been brought back to the brink and we could have entered a full-blown depression, wiping out Volt in the process. So…yes – there is always a way to lose money. Still, the key is trying to minimize those risks by investing in companies with:

  • an “edge” that virtually ensures higher profits for many years to come, and/or
  • a balance sheet with quality assets and manageable liabilities.

Then…you have to pay such an attractive price that the risks of losing money are minimal at best.

They won’t all be like Volt – moving almost straight up from the point of purchase. In fact, more times than not, they’ll be more disappointing than not because you’ll never know when the fear will pass and the party will start. They’ll be volatile; they’ll be ugly. Then again…that’s what makes them so beautifully attractive.

(Why didn’t I buy it at $4 back in March? It wasn’t on my radar!)

Looking Back at Mistakes

It’s always good to go back over past investments and see what worked and what didn’t. If you can sort through your past holdings and ignore the “lucky” ones, you’ll probably begin to find that your mistakes (and my mistakes) led to losses because the companies in which we invested didn’t have a strong enough edge or didn’t offer a solid enough financial base, and we paid too much money for too little quality.

Investing is all about looking into the future; so, it’s impossible to know for certain whether or not today’s purchases will be long-term winners. Still, you’ll be amazed at how much risk you can mitigate and how satisfactory your results will be if you simply focus on paying cheap prices for good assets surrounded by fear, where the risks to those assets are grossly overestimated.

Other Purchases

We also invested in three other companies in this quarter, and I’ll get to those in a future post. Four companies purchased in three months – now you see why I haven’t been around! Thanks for your patience with my absence!

A Note From Joe Ponzio

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