A Glance At Sharper Image

October 25, 2007 by Joe Ponzio

In the earlier years of his investing career, Buffett is said to have had more ideas than cash-a situation that has reversed itself as Berkshire’s asset base has swelled. In 1999, Buffett reportedly claimed he could earn 50% a year in the stock market if he had just $1,000,000 to invest.

Where would he look to do that? Pabrai claims that early, or low-asset, Buffett would look to buy $0.50 dollars and sell them when they reached 90% to 100% of their true value. He wouldn’t be a buy-and-hold investor; rather, he’d look to buy quick-hit (read: 1-3 year) investments.

And with that, let’s take an early Buffett look at Sharper Image (SHRP).

Break-Up Versus Intrinsic Value

Every company has two values-the end-operations-and-break-up value and the ongoing business (intrinsic) value. When you buy at a discount to either of those, you’ll likely come out ahead-assuming things don’t go wildly wrong at your company.

When Wall Street overreacts to bad news, companies can fall out of favor quickly. Prices can drop below intrinsic value, and continue to plummet below break-up value-and business investors can often profit quickly. Case in point: Sharper Image.

Bad News Turns Into Panic

On October 11, 2007, news hit the street that Sharper Image’s sales declined 39%. That same day, a federal judge rejected a proposed class action settlement against the company. Over the next two days, SHRP dropped 52%-from $3.70 to $1.77 a share.

High uncertainty. Big scare. Big profit potential.

Forget Intrinsic Value: Break Up The Company

Admittedly, I can’t figure out the intrinsic value of Sharper Image. I have no idea if they’ll pull out of the mess they’re in and I don’t know if it will ever generate cash again. Fortunately, I don’t have to know that. There are a million opportunities out there. Still, on such panic and selling, I had to take a look early last week.

It initially hit my radar on my stock screener as I looked for companies that were trading at 50% or less of book value. The screener is a lovely place to start looking for ideas-and Sharper Image warranted a closer look.

As I read through the recent reports and worked the numbers, I derived a rough, fire-sale break-up value for Sharper Image between $3.50 and $4.50 a share. In this game, you don’t have to be precisely right-you just need a great margin of safety to protect you when you are wrong.

The Margin Of Safety

Trading at $1.77 a share, Sharper Image was offering a 50%-75% discount from its break-up value. One could essentially buy the company for $1.77 and quickly double their money just by shutting down the doors. Or, we could buy a piece of the company and quickly double our money when Wall Street realized what a mistake it made.

And that is precisely what happened. (Click the image for a larger chart.)

Price Follows Value: Break-Up or Intrinsic

For the most part, the markets are generally efficient. When a company (e.g., Sharper Image) has such a horrendous outlook that it may not survive, Wall Street will generally price the company around its break-up value. Why? For one, Wall Street doesn’t know how else to price it.

But the markets aren’t entirely efficient, and people will buy or sell with absolutely zero information and 100% emotion-be it greed or, in the case of Sharper Image, fear.

Modern Pabrai, Early Buffett Play

In the case of Sharper Image, the goal was to buy a grossly underpriced business, and then sell it when it reached 90% or so of its scared-but-no-better-price break-up value. To make the numbers simple-buy between $1.80 and $2.25, and sell at $3.25.

With no easily calculated intrinsic value, and with a break-up value conservatively around $3.75 a share, there is no reason to hold this company for the long-term. Still, a $0.50 dollar is a $0.50 dollar, and those are always good buys.

Do that once or twice a year, and you can earn 50% or more-just like Buffett.

Side Note: Dabbling In $1.00 Stocks

Last week, I mentioned that the break-up might have been $5.60, but further research showed $3.50-$4.50. Following that post, I got an e-mail from someone saying:

You are an aggressive idiot. There is a reason it is a $2 stock-it is a bad buy!

The fact that a company is priced at $2, or $1, or $0.10 has nothing to do with whether or not it is a good or bad buy. In fact, Berkshire Hathaway can be a $1 stock. All Buffett would have to do would be to split the stock 127,000 to 1 and voila!-a $1 stock.

With 15.2 million shares out there and a break-up value of roughly $60 million, Sharper Image is worth roughly $4 a share (break-up might be slightly higher or lower, hence the price range). Don’t want it to be a $4 or $2 stock? If Sharper Image did a reverse split-say, giving shareholders one share for every ten they owned, Sharper Image would have about 1.5 million shares outstanding. The break-up value would still be $60 million-now roughly $39 a share ($60 million / 1.5 million shares).

The price of a stock is a function of the number of shares outstanding. Don’t sweat stock prices. Instead, find value and buy it when it’s on sale.

A Note From Joe Ponzio

This section is for comments from F Wall Street visitors. Do not assume that Joe Ponzio agrees with or otherwise endorses any particular comment just because it appears or remains on this website.